To Target-Date or Not To Target-Date?

Target-date funds are a convenient and easy way to invest for a specific time-bound goal. However, they may not always be the best option for your plan.

You may already be invested in a target-date fund inside your workplace retirement account. The Pension Protection Act of 2006 allowed employers to enroll employees in the retirement plan automatically. Furthermore, the PPA permitted employers to use target-date funds as the default investment solution. So, today, many employers do automatically enroll their employees in a target-date fund. Now that you may already own a target-date fund or are evaluating whether to use a target-date fund, we should explain how they work.

Target-date funds are primarily designed to help fund owners easily manage risk as they get closer to a date where they need the capital in that fund. The "target date" is the year in which you plan to begin using those funds. Because you likely require those funds in that year, you wouldn't want that fund's value to be exposed to significant value fluctuations. The fund manager controls the fund's volatility by changing the mix between more volatile stocks and less volatile bonds and cash throughout the fund's life. The manager uses a "glide path" or a determined schedule that dictates how the balance between the riskier and less risky assets changes over time.

For example, let's say you plan to retire at age 64, and you were born in 1986. And you plan to use a target-date fund for retirement. This means you plan to retire in the year 2050. So, one could pick a 2050 target-date fund. And throughout owning that mutual fund, the risk will gradually diminish as you approach 2050. So, in 2030, the fund maybe 80% in stocks and 20% in bonds and cash. Then in 2040, the fund maybe 60% stocks and 40% in bonds and cash. Finally, in the year 2050, the fund may be 45% equities with the remainder in fixed income instruments at retirement.

As you can see, the fund manager regulates risk by reallocating the mix between stocks and bonds. Remember, we generally see stocks are more volatile and thus riskier assets. And we see bonds as less volatile assets. Both still possess their own risks.

It is essential to keep in mind that as investors, we expect the more risk we take, the more reward we will receive. It does not always work out that way, but we see this pattern emerge over extended periods. So, as the target-date mutual fund manager shifts the assets from more risky investments (stocks) to less risky assets (bonds), we expect the returns to decline. The shifting risk/return profile of the fund is vital to keep in mind because you may find that if you own a target-date fund and you are in your 40s, the fund may have less risk than you need to reach your goals. Only careful analysis of your goal's needs and expected returns for the glide path you are on will help determine if you are on track or not.

Professional investors manage target-date funds. And all managers have our own opinions on how best to direct money. Different management styles are why not all target-date funds are the same. Some funds deploy active investing techniques; other funds use passive index-based methods. Some may tilt toward different investment strategies, such as being more exposed to small-caps or more invested in growth stocks. Target-date funds are typically fund of funds. So, they will typically consist of a mix of other mutual funds. Funds of funds can have multiple management teams embodied in one investment vehicle. By looking at a Morningstar Report or even the fund's prospectus, you will often be able to discern what securities the fund holds and the fund's investment philosophy.

Understanding how the fund invests and manages its capital is essential. The management style and investment philosophy will impact the fund's cost structure and forecasted returns. And as investors, we want to control costs in the best way to increase expected future returns. We also want to make sure the fund manages your assets for the amount of risk you can tolerate and need to take.

So, when is it appropriate to be invested in a target-date fund? As always, it depends on your unique circumstances. But here are some points to think on:

• First, target-date funds are helpful to use when you need an easy way to begin investing. Target-date funds are a quick and easy way to have a one-fund solution for your stated goal. And if you are starting, these funds can help you begin investing. Target-date funds are typically well-diversified into many different industries, locations, and company sizes. And the nice thing is that the fund manager will rebalance the allocation when needed. Rebalancing helps keep the fund's risk profile in-check with your target date.

• Second, a target-date fund may make sense if there are few other low-cost, index-based options in your retirement plan, and the target-date fund available is a low-cost index-based solution. I generally recommend folks use index-based funds for their investments (which is a whole other topic of discussion).

• Last, Target-date funds may make sense if you need a suitable investment for a small account that you don't want to place a lot of effort into managing. Have a small Roth IRA or Traditional IRA? Using a passive index-based target-date fund for these small accounts can provide automatic rebalancing at a low cost.

So when is it likely not okay to use a target-date mutual fund? Again, it depends on your circumstances, but here are some thoughts:

• First, it is likely not appropriate to use a target-date fund if it does not match your risk tolerance, need, and capacity. If you have made SMART goals and find the target-date fund will not meet your goal's needs, it likely means the fund is not the best investment strategy for you. Furthermore, if you can stomach more risk than the fund is currently experiencing, you may want to reconsider. And last, if you have additional capacity to take on more risk, it may be appropriate to review using a target-date fund.

• Second, a target-date fund may not be right for you if the fund's allocation does not match your judgment. It may not be appropriate because you disagree with the investment philosophy. The management style may not align with your values. Or, you may outright disagree with how the fund invests your capital. Things to consider when evaluating a fund's investment management style should include:

Is this an active or passive mutual fund?

Does the fund have adequate international exposure?

Does the fund invest in quality bonds and cash instruments?

How long has the manager led the fund?

Does this fund focus too heavily on growth or value stocks?

Is there an adequate representation of small-cap stocks?

Does this fund's allocation complement my existing retirement accounts?

• Next, if the fees are expensive, you should consider more affordable alternatives. As investors, we are always trying to manage risk and return. Reducing expenses is an excellent way to manage your investment portfolio's expected returns.

• Suppose your retirement plan administrator or custodian allows you to rebalance between low-cost, index-based funds quickly. In that case, it may make sense to save on the costs of owning a target-date fund and do the rebalancing yourself. Not all custodians make it easy to rebalance. But if your account's online portal makes it easy to rebalance periodically, then doing it yourself may make sense.

And last, there may be too many choices, and you are becoming paralyzed in making a decision. If this is the case, it may make sense to work with a professional planner. Life is complicated, and as you can see, Target-date funds can offer simplicity. Still, that simplicity can come at a cost. The fund may not be most suitable for you. Evaluating investments is a lot of work. And working with a planner can help you with workload and stress. Working with a financial planner brings a professional perspective to your situation. A good planner will educate you to help you through the decision process. A financial planner will help you formulate specific goals, review your current situation, help you determine how much risk you can take on, and how to execute your strategy.

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