After you start contributing to your workplace retirement accounts and your Roth IRA—and perhaps even a Health Savings Account—you then have to decide how to invest these contributions.
One option is going with a target date fund that aligns with the time frame for when you think you might retire.
While doing so isn’t likely your worst option—that would be just letting your contributions sit there doing nothing while inflation eats away at your purchasing power—I also don’t think it’s the best option.
What is a Target Date Fund
Target dates funds have a variety of names—I’ve also seen them referred to as Lifecycle Funds—but the name matters less than the function: these funds invest your contributions in a way that theoretically limits your risk according to how close you are to retirement without you having to do anything.
How do they do this? Each fund is made up of other funds that reflect different investment options, such as stocks (both domestic and international) and bonds.
Bond funds are generally thought of as less risky than stock funds because history has shown that, while your investment can go down with bonds, it is unlikely to go down by a lot (although the opposite is true too: it is also unlikely to go up by a lot).
As people near retirement, the theory goes, they will want to have more of their savings in bond funds because that means it is more likely the money will still be there when they need it.
Target date funds move money from stock funds to bond funds automatically as the years go by. For example, as I’m writing this, the Vanguard Target Retirement 2025 Fund is 62.85% stock funds and 37.15% bond funds. In contrast, the Vanguard Target Retirement 2065 Fund is 89.93% stock funds and only 10.02% bond funds.
This means that people who are seven years out from retirement—the “2025” in the name of the fund indicates the year of retirement the fund is geared toward—are more protected from the fluctuations in the stock market than people 47 years out from retirement. Why? Because the people who won’t need to access their investments for many decades are in a better position to absorb a loss.
Why Do Target Date Funds Exist
I could be cynical and say that these funds exist because companies that offer them thought they would be profitable but I will be generous and say that this is only partly true.
Many, I’m sure, saw a need to create hands-off investment options after witnessing clients religiously contributing to retirement accounts, expecting to have a nice nest egg built up, only to discover that these contributions had been sitting in a money market account earning barely enough to stay level with inflation.
Why I Don’t Like Target Date Funds
Despite the (possibly) good intentions that inspired these funds, I still don’t like them. That’s because I don’t think planning for retirement is a one-size-fits-all, set-it-and-forget-it proposition. And here’s why.
They Give You an “Out” When I Comes to Investing Your Money
Educating myself about my money has been critical to so many of the positive changes I’ve made in my life over the last couple of years. I don’t think I would have ever succeeded in paying off almost $60,000 in debt in 16 months if it hadn’t been for monitoring my net worth and seeing how those obligations were keeping me from maxing out my retirement savings.
By allowing you to be hands off with your investments, target date funds take away any motivation to take charge of how your money is allocated.
Investing isn’t as hard as you may think—it’s certainly not as hard as I expected it to be (and it’s way more fun). But I only know that because I took a more active role.
They Aren’t Aggressive Enough
When I first started reading up on investing, I would often come across advice that the percentage of your portfolio you should have in bonds should be equal to 100 minus your age or, if you were daring, 110 minus your age.
Now, however, given that a woman retiring today at age 62 in good health who has never smoked is likely to live another 24 years, this recommended ratio worries me. Continued growth will be important if she is not going to run out of money in retirement.
In this sense, the riskier proposition is to be too conservative.
They Don’t Take Into Account Your Specific Circumstances
Very few peoples’ retirements are going to look the same, yet these funds treat all accounts as equal.
For example, I’m hoping to retire from W-2 employment no later than 57 which means I will need to maximize growth opportunities right up until I retire. Yes, it might be “safer” to increase the portion of my money invested in bond funds and decrease the portion invested in stock funds, but “safe” may end up backfiring for me if it means limiting growth.
If the market takes a dive, I may need to work longer but if I don’t invest for growth I am almost guaranteed to have to work longer.
How Creating My Own Mix of Investment Funds Benefited Me
I will use my own experience as a case study for how doing your research and understanding your risk tolerance is worth your time.
I have been with my employer for 13 years and have contributed money toward my retirement since day one. My contributions have varied but between 2005 and 2017 they averaged 10.5% of my salary (my employer contributed another 5%).
I do not consider myself an active trader but I did typically go into my account several times a year and move money between the small number of index funds available to me. I did this guided by the data I had gathered about the fund options, what was happening in the market, and my gut instinct for how much risk I was willing to tolerate given the number of years I had until I expected to retire.
The result has been higher growth in my investments then if they had been invested in the 2040 fund offered by my employer (when I started, this was the fund with the longest investment horizon and the fund I would have invested in had I invested in a target date fund).
In fact, my comparable return for the years for which I have data, 2007-2017, was significantly higher: 10.34% compared to 7.55%.
Am I an investment genius? Of course not. But with a little research I designed an investment strategy that met my needs instead of relying on an algorithm. Could I have had a lower return? Certainly. But I am convinced my ability to stay on top of my investments and to nimbly respond to what was happening allowed me to do what Warren Buffett recommends: buy when everyone is selling and sell when everyone is buying.
However… (This is the “Love” Part Alluded to Above)
If you are certain that—no matter how much sense it makes—you will not research the various funds available to you to decide what to purchase and in what quantities, then target date funds are probably your best bet. I’ve even said as much to friends.
For example, I have a friend who started with my employer the same day I did who is nine years younger than me. A few years after we started, we were talking about retirement and she mentioned in passing that she still had her money going into the default fund which at that time was the option geared toward growth equal to inflation.
While I definitely wasn’t as interested in investing back then as I am today, I knew enough to know that at her age this was not the fund she should be investing in.
I prodded a bit more and she revealed how anxious she felt about retirement planning and her fear that she would mess it up somehow and lose all her money. I assured her that this was unlikely but if she was that scared then at a minimum, she should look into the target date fund option, explaining that it was a professionally managed fund that would adjust her risk based on her age.
If you have avoided investing your contributions for similar reasons, then investing in a target date fund you have access to is worth looking into.
What’s Your Opinion of Target Date Funds?
Do you invest in target date funds or do you prefer to design your own strategy?