Target funds can make sense for a small group of people but they are foul investment choices for everyone else. There are three fundamental problems with these investments. Before we get to that let’s review what a target fund is.
What Is A Target Fund?
A target fund is a managed mutual fund that is supposed to tapper risk as you age. They are sometimes known as lifestyle funds. They do this by gradually shifting the allocation of securities each year away from equities and moving that money over to bonds instead. By the time the fund owners retire, the target fund might have 60% or more of the assets invested in bonds. So why are target funds just wrong?
1. Too Conservative Too Fast
Target funds transition money from equity over to bonds as the years go by as I said. This is done ostensibly to reduce risk. The argument is that your portfolio should be very conservative on the day you stop working. That’s why they heavily favor bonds over time. But that thinking is simplistic and dangerous. Here’s why.
Once you retire, you probably want to stay retired for a long time. If that’s the case you need your retirement funds to generate income for as long as you live…right? That might be 20 or 30 years after you retire. Bonds are dangerous because the income is fixed and there is no adjustment for inflation.
Neal’s Notes: Looking for more proof? Recent studies reveal more problems with target date funds making these even less attractive. Beware Pilgrim.
In fact, if you plunk all your retirement assets into bonds you might increase the risk of going through all your money before you die. Bonds are a great hedge against stock market volatility. But they aren’t a good hedge against inflation. And if you think about the next 30 years of your life and don’t make allowances for inflation you’re looking for trouble.
Right now, this problem is especially pronounced. Why pile money into long term bonds with interest rates so low? I can’t see the sense of it…can you? Probably not. But target funds don’t consider current market conditions they just plow your money into bonds based on the calendar and ignore the market. In my opinion, that’s a “no bueno grande”!
2. No Safe Harbor
From all this talk about how target funds focus on safety, you might be surprised to learn how risky they can be. In fact many expose investors to far more risk than they imagine.
In 2008, the average 2010 target date fund cratered 23% according to Morningstar. Keep in mind that if you owned a 2010 target date fund in 2008, you expected to retire in 2 years. If you bought a target fund you expected the fund manager to be true to her word and hold very conservative securities. Sadly, most target fund managers didn’t deliver. Why not? Marketing.
Remember, target funds compete with each other for investors’ dollars. They want to put up high return numbers to catch your attention and business – even though they market themselves as an answer to stock market risk. As a result, some managers stuff the fund full of very aggressive investments and the unsuspecting investor picks up the tab.
3. All Target Funds Are Not Alike
You might think that all target funds are alike but that’s not true. Each fund has its own manager and a unique prospectus that governs how the fund invests. That means different target funds with the same maturity date often have vastly different holdings. In fact, on the day you retire, some funds might have as much as 70% in equity and others might have as little as 20%. The only real way to know what you are getting involved in is to read the fund prospectus.
Where Target Funds Do Make Sense
Target date funds don’t work for retirement investing as I’ve demonstrated. But they might be smart if you have a college savings 529 plan. That’s because 529 plans are designed to be depleted over a short time – 4 or 5 years – once your student starts school. As a result it is smart to have the money very liquid and very safe once he or she hits age 18.
But again, retirement assets are very different. Once you start tapping into your retirement money you want to withdraw that scratch over a very long period of time. As a result, you need more control over the equity component of your retirement assets. Target funds don’t work because they often shift your money into bonds way to fast and can expose you to investments that are far riskier than they would otherwise feel comfortable with.
Do you own target date funds? What has been your experience?
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