Saturday, December 11, 2010

Targeting Target Date Funds

You may have heard about target date funds (or life cycle funds as they are sometimes called) as they have grown in popularity over the past decade.  What are they?  They are mutual funds that are offered by an investment company that automatically adjusts their mix of assets over time.  The theory is that if you are far away from some investment goal (usually retirement) you can afford to invest in more risky assets like stocks, since over long periods of time, riskier assets have the best returns.  However, as you get closer to your investment goal, you will want to shift your investments into less risky investments since you have less time to recoup any investment losses.  These funds automatically adjust based upon this strategy.

Most companies offer various target date funds.  You pick the fund whose target date is close to your retirement date, and the fund adjusts the asset mix as you get closer to retirement.  Let's say that you plan to retire 20 years from now in 2030.  You would choose a target date fund whose target date is 2030.  In 2010, that fund will be more heavily invested in stocks since you still have 20 years to go before you need the money.  However, as you get closer to retirement and beyond, your exposure to stocks will decrease until it reaches some minimum amount.

Why would somebody invest in a target date fund?  The biggest advantage is that these funds are truly "set-it-and-forget-it".  You simply deposit the money in the fund, and you don't have to worry about constantly adjusting the asset mix over time.  All you have to do is pick the fund whose target date matches your expected retirement date. 

On the other hand, this set-it-and-forget it advantage is a double-edged sword.  The disadvantage is that not all target date funds are created equally.  Some funds might take more risks and some might take less.  As an example, I took a look at three popular target date funds:  Fidelity Freedom 2030 Fund, T. Rowe Price Retirement 2030 Fund, and Vanguard Target Retirement 2030 Fund.

As of today, all three have about the same asset allocation more or less:  60-65% domestic stocks, 16-17% international stocks, and the rest in bonds.  So far, the all look about the same.

When the funds reach their target date of 2030, again all three will have about the same asset allocation:  around 40% domestic stocks, 10-15% international stocks, and the rest in bonds and other short term investments.  Still not much difference.

However, the difference comes in after you reach retirement.  All three funds continue to decrease their exposure to stocks after retirement, but the rate at which this happens varies.

The Fidelity fund is scheduled to eventually get down to about 20% stocks after "10 to 15 years after the year 2030" according to the prospectus.  That means that you will reach 20% sometime between 2040 and 2045.

The T. Rowe Price fund invests more aggressively in retirement.  Again, the fund is scheduled to reduce its stock holdings to 20%.  However, it is scheduled to reach this level in 2060, 30 years after retirement.  Because it reaches its 20% minimum over a longer period of time than the Fidelity fund, the T. Rowe Price  fund stays invested in stocks for longer.

The Vanguard fund is the most aggressive of all in retirement.  This fund reduces its stock holdings to 30% which is higher than the other two funds.  It reaches this milestone about 10 years after retirement.

The person who is likely to invest in target date funds is not likely to look very closely at how a target date fund invests.  They are looking for an investment that they don't have to think about.  However, an investor might find that the investment philosophy of the fund doesn't match his or hers.  For instance, an investor who has a low risk tolerance might not feel comfortable having 30% invested in stocks during retirement.  This person would be better off with the Fidelity fund.  However, that person might not take to time to look at how the fund invests and will only realize that the fund is too risky after taking losses when the stock market dips.  On the flip side, an investor who is more aggressive would be better off in the Vanguard fund because it keeps more money in stocks during retirement.

The lesson here is that target date funds might be a good thing for people who don't want to think too much about investing.  However, that doesn't mean that you don't have to do your homework.  You still have to have some understanding of what you are getting into so that you pick the target date fund that matches your investment goals and personality.

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