Target date funds are some of the most popular investment choices among retirement plan participants today. I understand why people put their money into these funds even though I think there are far better choices. But investors may not understand exactly what they are getting into when they pull the target date fund lever and they may underestimate some of the risks they take when they buy these funds now.
What Are Target Date Funds?
Target date funds are mutual funds that become progressively conservative over the years. That means that each year the manager sells off equity and puts more money into fixed income.
This appeals to people who believe their retirement investments should become more conservative as they approach retirement. I have already demonstrated why this is probably not a good approach. But let’s look at the unique risks these investments pose right now.
The Special Risk of Target Date Funds
Because target funds buy more and more bonds each year investors are exposed to greater risks right now. That’s because bonds prices could become more and more volatile if the Fed changes its interest rate policy – something they’ve been threatening to do. Interest rates have been abnormally low for some time now. If they rise to normal levels, bond holders could take a bath.
And of course this would be especially painful to people who are just about to retire. Remember, the people who bought these target date funds did so precisely because they wanted their money to be safe and secure the day they retire. But because of the unique circumstances we now face, those people might end up being painfully disappointed when they can least afford it.
What Target Date Fund Investors Can Do
There are two strategies you can use to help mitigate the potential risk of decreasing bond prices. First, you can dump target funds entirely – that’s my preference. I say that because target date funds don’t really serve you that well.
Remember, you need your retirement funds to provide retirement income all your life. And you need some way to combat inflation over that time period. For most people, that means the money has to keep working for a good 20 or 30 years after they retire. And that means you probably need some equity in your allocation. The provides a better way to create the income you need in my opinion. It might feel nice to have a very conservative portfolio on the day you retire – but it probably isn’t going to maximize your income over your life.
If you still want to own to own a target fund, make sure the fund manager is smart about the bonds they hold. Go through the prospectus and review the bond maturities. If possible, consider target date funds with shorter term maturity bonds as opposed to longer term bonds. That’s because shorter term bonds typically don’t drop as much as longer term maturities drop when rates rise.
Target date funds are marketed as a great retirement investment that plan participants really don’t have to think or worry about. As you can see, quite the opposite is true. Interest rates are poised to rise and that might clobber bonds. And target date funds are pouring more and more money into bonds as the investor ages. In my way of thinking, the math on this is pretty easy. Just say “no” to target funds right now.
Do you buy target date funds? Why? Are you concerned about rising interest rates?