The wonderful bloggers over at Millennial Revolution had an excellent post last week they entitled “Is Too Much Freedom Bad For You?” Personally, I think the answer to that question depends on the person. Politicians constantly promote the idea of freedom. More choices will drive down the market. The amount of choices we have on the internet is fantastic. The amount of television shows makes this a great time to be a fan of TV. That maybe true in the abstract, but it doesn’t necessarily translate into our own personal behavior. For example, if you were to track your own internet usage on a weekly basis you would find that most of us visit the same websites every day. In fact, I would suggest to you that most of us don’t use the freedom we do have. We like the veneer of it, but we rarely use it. It is the threat of it being taken away that hurts most of us.
This translates into personal finance in a number of ways, but for the purpose of this post I want my focus to be on mutual funds. One of the things that I hope to do in the future is become a financial coach where I can work one on one with people helping them with personal finance issues. Perhaps this will eventually lead to teaching some courses as well. The purpose of this coaching, in part, is to help people try to get their retirement financial house in order. It is no secret that we have a retirement crisis in America. There are a number of studies out there, but at least 1/3 of working Americans haven’t saved a dime for retirement. Not one cent. Couple that statistic with the fact that over 71% of Americans aren’t saving enough for retirement. I don’t know about you but that should scare a lot of us.
Personally, I think saving for retirement (on top of Social Security) should be mandatory. I think if your employer has a 401k plan that you should be automatically enrolled in it. If you don’t then you should have a small portion of your wages put into an IRA plan that you can manage. This retirement requirement finally brings me to the subject I want to further discuss: Target Date Mutual Funds.
What is a Target Date Mutual Fund?
One of the biggest complaint you hear from people who try to save for retirement is that it is extremely confusing. People have a 401k plan, but they don’t know what to invest in. How much should I put in stocks? bonds? What funds should I choose? I am an advocate of index funds, but not all retirement plans offer them. So what is a person to do? The answer to that question is why they created Target Date Mutual Funds.
A target date mutual fund is a fund that has a date attached to it typically when you would want that money for retirement. In other words, let’s say you are 25 and you want to retire in 40 years. Well, you would choose a target date fund of 2055. Different brokerage firms (e.g. Fidelity) have different names for them. For example, Fidelity often calls their target date funds Freedom Funds. The idea of the fund is that the further out you choose your retirement the riskier the investments will be. The reason for that is that you have a long-time that you will need those monies. Thus, you can take more risk as time goes on. However, the closer the target date, the more conservative the investments become.
The point of the target date fund was to give people simplicity. If you want less risk you choose a target date fund that is closer to the time that you invest. For example, if you invest in 2015 and you are conservative maybe you choose a 2025 target date fund where there is more emphasis on bonds in the fund than stocks, which makes it less risky. Of course you don’t get a higher return, but you wouldn’t lose as much money if the stock market were to go south either.
A target date fund is meant to provide simplicity for the investor where you choose the amount of risk you want to take. The further away the date of the fund you choose the fund’s allocation will have more investments in stocks and other volatile assets. It is riskier, but comes with greater return. As the target date gets closer, the fund is supposed to being to start taking less risk.
In other words, for some people who don’t understand stocks, bonds, and the market in general this can be a great way to invest. It is basically a one-stop shop. All you have to do is contribute and they take care of the investing, rebalancing your portfolio, and the like for you.
Disadvantages of Target Date Funds
Target date funds sound pretty good right? Particularly, if you are confused about investing. It is a one-stop shop for you the investor. However, there are some disadvantages to these funds.
- Different brokerage firms have different types of funds. So the major brokerage firms like Fidelity, Vanguard, T. Rowe Price and others have all created different types of target date funds. However, those funds aren’t necessarily equal. In other words, the investments in a Target Date 2040 fund from Fidelity, might be different than one from T. Rowe Price. Sometimes it might be difficult to navigate which is better.
- High Fees on Target Date Funds. Some of the target date funds come with high investment fees. For example, the Fidelity Freedom Funds often come with expense ratios of .75%. That doesn’t sound like a lot but over years it can add up to lots of money. By contrast, the expense ratio of an index fund can be as little as .05% which can save you a ton of money. However, they have now created Target Date Index Funds with a expense ratios of .1%. If you don’t want to create a portfolio of index funds like I have and just want to go with one fund where they do the investing and allocations for you then this might be a great choice.
- Sometimes the asset allocations are too high. The idea of the target date fund is that the closer to the target date the more conservative the investments become. However, that isn’t always the case. Often, these target date funds are actively managed, which means that a team of managers (or just one) is actively picking and choosing stocks. They sometimes do not always become more conservative as time goes on. And different brokerage firms will have different allocations depending on the manager.
- Availability in your retirement plans. The unfortunate thing is that target date funds are not all available in different 401k plans. Moreover, the target date index fund (which I like better) isn’t available. For example, we have target-date funds in my 401(a) and 403(b) plan at work. However, I DON’T have a target-date index fund available. I don’t want to pay those large expense ratios so I create a portfolio on my own. If we did have them available I might invest in them.
The Bottom Line: If you are confused about where to put your investments a target date fund might be right for you. Too many choices can cause analysis paralysis and it is better to be investing than sitting on the sidelines. A target date fund can be good because then you don’t have to choose a portfolio of index funds or other mutual funds. If you had to choose I would choose a target date INDEX fund instead of a regular one. If it doesn’t have INDEX in the title I wouldn’t bother with it, but that is my opinion.
Even if you choose a target date fund you still should to become educated on asset allocation, your risk tolerance, expense ratios, the basics between stocks and bonds. Even with target date funds you need to keep an eye on your money and educate yourself about its opportunities.