Hands-off investing has become de rigueur among America’s youngest workers.
According to Fidelity, those between the ages of 22 and 34 overwhelmingly favor target-date funds for their 401ks, with more than half its clients in this age group investing their entire retirement accounts in these funds.
For those unfamiliar with target-date funds, they automatically adjust the allocation between stocks and bonds as you age (less stocks and more bonds) on your way to retirement.
However, while target-date funds are popular with young adults, they aren’t always the best product to own. Sometimes there are better alternatives, such as balanced funds. So when is a target-date fund worth it?
Why Target-Date Funds Have Exploded
Most young people invest in target-date funds because it takes the investment decision out of their hands. Rather than learning about how to invest a buck, they’re passing it.
I think everyone can at least relate — investing isn’t exactly easy, nor is it always fun.
The federal government has further played into the hands of the financial services industry by making target-date funds a qualified default investment alternative (QDIA). According to pension consultant PlanPilot, the Department of Labor introduced regulations in 2007 that said QDIAs were investment options that a plan sponsor could direct contributions to where a participant hasn’t chosen a specific investment. Further, the rules said QDIAs should be a “product with a mix of investments that takes into account the individual’s age or retirement date.”
That’s essentially the definition of a target-date fund — and business boomed.
A Securities and Exchange Commission report from April of this year stated in its findings: “Roughly 70% of US employers report offering target date funds as their default investment option for company-sponsored defined contribution plans …” Further, Fidelity suggests 84% of plan sponsors offer target-date funds, up from 45% in 2007.
However, just because they’re readily available doesn’t make then the right choice.
When Is a Target-Date Fund Worth It?
There are many reasons why younger people should consider investments other than target-date funds for their 401ks, not the least of which is the simple concept of self-responsibility. No one owes you a safe and secure retirement. Gone are the days of gold-leafed direct benefit pensions. The size of your retirement fund is directly in your control; if you choose a target-date fund opting to let someone else handle the heavy lifting, you can’t be upset when you hit retirement and your nest egg isn’t up to snuff.
It’s like the old saying, “If you don’t vote, you lose the right to complain.”
I believe it’s best to own a target-date fund when you’ve done your homework and understand exactly what you’re getting.
First, there are fees to consider. Morningstar indicates that the asset-weighted average expense ratio for target-date funds was 0.91% in 2012, down from 0.99% in 2011 and 1.04% in 2010. In other words, for every $1,000 you have invested, the fund manager receives $9.10 annually regardless of performance. That’s far more than ETF fees.
If your 401k offers a target-date option like the Vanguard Target Retirement Series, which charges an average of 0.15% annually, you know you’re not getting hosed.
Next up is something called “glide path.” No, I’m not veering off into aeronautical science. Rather, it’s the degree to which your target-date fund adjusts the equity component of the holdings each year. There are two types: funds that manage the asset allocation “to” retirement and those that manage the asset allocation “through” retirement.
It’s a complicated subject, to be sure, but what’s most important is that the fund manager isn’t taking his or her foot off the gas too soon. For example, in your 20s it makes sense to own mostly equities because you have plenty of time to recover from market downturns such as what happened in 2008. Look for glide paths that don’t ratchet up the fixed income component too early as you could outlive your retirement savings.
I know in my parents’ situation (my dad died this year at 81; my mom is 79), the fact they kept investing in equities well into their retirement helped with their nest egg. Bonds wouldn’t have cut it over the last three years.
Another important factor in target-date funds is what’s actually held in the fund. You wouldn’t order a pizza without knowing the ingredients; the same holds true for target-date funds.
For instance, in the case of Vanguard Target Retirement 2050 Fund (VFIFX), its asset allocation is 90% equities and 10% bonds. It achieves this by investing in four Vanguard mutual funds including the Vanguard Total Stock Market Index Fund (VTSMX) and Vanguard Total International Stock Index Fund (VGTSX), which account for 63% and 27% of the portfolio, respectively.
The target-date fund’s prospectus states that by 2057, it will be 100% invested in fixed-income securities, which tells us its glide path is “through” retirement and not “to” retirement.
I’m a big believer in the KISS method of investing — keep it simple, stupid.
It’s great that young people are saving and investing so early. However, it’s all for naught if you don’t understand your investments from top to bottom. Furthermore, if your company offers a 401k contribution match, make sure you maximize that freebie. Not doing so is equally inept.
So when is a target-date fund worth it?
When you understand how it works and the reasons why you’re investing in it. Until then, you’re playing fast and loose with your hard-earned money.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.