Do you remember when you started your job and were presented with the opportunity to participate in your company’s retirement plan (401K / 403b)? Knowing that it was probably a good idea to save for retirement you enthusiastically signed up. One question you were asked is what percentage of your income would you like to contribute? This sounded simple enough so you chose a nice round number, for example 5%. After that, you were provided with a number of investment choices to make. Now it started getting a bit tricky.
The process of deciding which investment to choose from can be straight forward if you understand the concepts of asset classes (cash, bonds, stocks), active vs passive index mutual funds, time horizon, investment risk, asset allocation, and portfolio re-balancing. The reaction that people have when presented with these concepts ranges from irritation to utter confusion. While there are customer service personnel available to help you make your decision, you have to take time out of your day to speak with them and hope they don’t add to your confusion.
Knowing that employees have been experiencing negative emotions around saving for retirement, investment companies created an investment product to make the decision easy for the employee. This is called the Target Date Fund. Some companies even make this the default investment option. The only information you need to know is the year you expect to retire. For example, if you are 37 years old and you want to retire in 30 years you could choose the Target Retirement 2050 fund.
This sounds simple enough but what exactly is a target date fund? A target date fund is a basket of mutual funds that holds a mix of stocks, bonds, cash, and other investments. The assumption that the Target Date Fund makes is that if you have a long time to go until you retire, the more investment risk you can afford to take and vice versa. Therefore, the longer you have until retirement the more stocks will be held in that target date fund. As you move closer to retirement, the number of stocks are reduced and the number of bonds are increased. The investments within the target date fund is designed to grow substantially, especially in your early years of savings and taper off and become more conservative as you get closer to retirement.
As you can see, Target Date Funds can be a simple choice. However, it is important to distinguish between simple versus safe. Some people think that Target Date Funds are safe investments because they are simple. On the contrary. Target date funds should be considered risky investments when they are invested at a young age. For example, the Vanguard Target Retirement 2050 Fund invests 90% in stocks. It can even be risky at later ages as well. If you are retiring in 10 years, you could choose the Vanguard Target Retirement 2030 Fund. Now, you would think the fund would be relatively safe because you are retiring in 10 years. However, the fund invests almost 70% of it’s investments in stocks.
It is important to make sure that the investments that you are making matches your investment risk tolerance (how much money you can lose and still sleep at night). If you were retiring in 10 years, would you be comfortable with 70% of your investments in stocks especially knowing it could potentially lose 30% if another crisis like the great recession happened? Chances are you would not be comfortable with that.
So, while a Target Date Fund is a simple choice to make, it might not necessarily be the best choice if your tolerance for risk is much lower than the risk being taken by the target date fund. In that case, while more difficult, it is better to choose individual mutual funds that matches your appetite for investment risk.
This content is developed from sources believed to be providing accurate information, and provided by Attune Financial Planning. Please consult your financial, legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information only.