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Keeping things simple is the best strategy for novice investors to follow. But before you use products designed to make investing easy, it's essential that you understand how they work and what risks they involve.
One such investment for retirement savers is the target-date fund. On their face, these funds seem about as easy to understand as you could get. Yet target-date funds burned many investors during the 2008 bear market, because investors didn't know the details of how their funds worked.
Understanding target-date funds
The concept behind target-date funds is incredibly simple. Many mutual fund companies offer a range of target-date funds, each geared toward a particular date. At least in theory, picking the right fund should be as easy as matching the target date of the fund to the year you expect to retire. So if you're 60 now, and you expect to retire in five years, then a 2015 target-date fund would be the obvious choice.
The real beauty of the target-date fund comes after you buy it. The innovation that target-date funds brought to the financial industry is that you never have to rebalance or adjust your portfolio over time. Instead, the fund itself becomes more conservative as you get closer to your target date, and it makes sure that you don't end up overweighted in a particular type of asset.
Sounds simple, right? But it turns out that there's more to these funds than meets the eye.
One of these funds is not like the others
The surprising thing about target-date funds is that there's actually a wide variety of different strategies that various mutual fund managers use. T. Rowe Price (Nasdaq: TROW ) , for instance, uses an aggressive strategy that assumes that your retirement assets will need to keep growing for as long as 30 years after the fund's target date. Its 2010 target date fund currently has nearly 57% of its assets in stocks, versus just 38% in bonds.
At the other end of the spectrum, the Allianz-distributed (NYSE: AZ ) PIMCO Funds include a 2010 target date fund with just 15% of its assets in equities. Bonds make up 56% of the portfolio, with cash at 17%, and real estate and commodities making up the rest.
As you can imagine, the mix of investments can make a huge difference to your returns. In 2008, stock-heavy target date funds plummeted, shocking investors just a few years away from retirement. The fallout was so negative that Charles Schwab (NYSE: SCHW ) chose to decrease stock allocations for its near-term target funds.
What to do
Fortunately, you have all the tools you need to figure out which target-date fund is right for you. In the fund prospectus, you'll find a description of the expected allocations throughout the fund's lifetime. If it looks good to you, go with that fund.
If you don't like it, though, there may be a simple solution: Pick the "wrong" date. If a fund seems too aggressive, choosing a date sooner in the future might give you an allocation more to your taste. If it's too conservative, picking a date that's further away may be the answer.
Here are some other things to consider when choosing a target-date fund:
- Don't pay too much. As with any mutual fund, fees mean money out of your pocket. You'll find a wide range of fees with target funds, as fund companies try to maximize profits from retirement savers. Wells Fargo (NYSE: WFC ) , for instance, has funds that charge about 0.9% annually. Principal Financial (NYSE: PFG ) even charges sales loads on its target-date funds. But Vanguard's similar fund weighs in at just 0.17%. Especially if you have a long way to go before you retire, extra costs can add up.
- Fill in the gaps. Some funds won't give you the exposure you want in every asset class. For instance, Vanguard's 2010 fund only includes a 2% allocation to emerging markets. If you want more, then you may want to supplement your target date fund by buying the iShares MSCI Emerging Markets Index (NYSE: EEM ) or the Vanguard Emerging Markets Stock ETF (NYSE: VWO ) . That way, you can custom-build the allocation you want.
Target-date funds are valuable tools to make retirement investing easy. But you have to do your homework. Only once you're sure your target date fund will work the way you want it to should you consider letting your investments go on autopilot.
You don't have time to waste when saving for retirement. Find out how you can keep the next 10 years from being as bad as the last 10.