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3 Questions to Ask Before Choosing Target-Date Funds
Target-date funds seem like an easy choice, but they’re not all the same.
Over the past few years, target-date funds have been growing in popularity. According to Morningstar’s 2014 Target-Date Series Research Paper, estimated net flows in target-date funds tripled from 2007 to 2013, growing from $200 billion to $600 billion. Before going any further, let’s briefly describe what a target-date fund is.
A target-date fund is a type of mutual fund that automatically changes its mix of stocks, bonds and cash based on a specific end date that is appropriate for a particular investor. In most instances, the date is viewed as the day someone will retire, although they don’t have to be used that way. For example, someone aiming to retire 35 years from now could choose a target date 2050 fund. Because it has a long time horizon, the portfolio would likely be weighted heavily toward stocks and would gradually allocate more in bonds as time passed.
With more and more people using these types of investments, you may find yourself wondering, “Should I be using target-date funds?” Whether you are two, 10 or 50 years away from retiring, you should answer these three questions before adding one to your portfolio.
1. How much control do I want to have over my investments?
If you consider yourself more of a hands-off investor and don’t mind buying something and holding it for a long time, then target-date funds could be a good fit. They have built-in diversification between stocks and bonds, they automatically rebalance and they are offered by companies that have been around for decades and oversee trillions of dollars, so you don’t have to worry that it’s not being managed by professionals
However, if the answer to this question is “a lot,” “some” or even “a little,” then target-date funds probably aren’t right for you. The biggest issue most people have with these funds is that you are letting someone else decide how to much invest in stocks and bonds over the life of the fund. What happens if, three years down the road, you change your outlook on the economy and you’d rather hold more bonds than stocks?
The only way to do this would be to sell your holding and buy a different target-date fund, which defeats the purpose of buying one in the first place. There’s nothing wrong with entrusting someone else to choose how much to invest in stocks versus bonds, but if you want any say in the matter, then it doesn’t make sense to buy a target-date fund.
2. What is the “glide path” for the target-date fund?
What’s core across all target-date funds is how they move to a more conservative allocation as the end date approaches, which is known as the fund’s glide path. What’s different is how they get there and what they do once you reach the end date. Some funds are designed to be nearly all cash once they hit the target date, and those types of funds are called “to retirement.” They focus more on keeping your investments stable, since one of their main goals is to minimize the potential for loss of principal as of the end-date.
The other kind of target-date funds are known as “through retirement,” and are built for investors who want their money to stay in the market after you reach the target date. Being retired doesn’t mean you don’t need to continue to grow your assets, right? The advantage with this type is that it lowers the chance that you’ll outlive the amount of money you have, which is known as “longevity risk.”
Both types of funds serve a specific purpose, but the bottom line is that you need to be aware of how the fund’s allocation changes through time before deciding if a target-date fund is right for you.
3. How important is tax efficiency to you?
This question is similar to the first question because it addresses the issue of control, but specifically from a tax perspective. Let’s assume you’re retired and all of your investments are taxable. Owning a target-date fund can be tax-efficient from the standpoint that it typically has low turnover and some of its distributions may be taxed at the long-term capital gains rate which is lower than the ordinary income rate. However, you miss out on other opportunities to reduce your tax bill.
For example, tax-sensitive investors like owning municipal bonds because the interest generated is not subject to federal income tax. Another way to lower your taxes is to do what is known as tax-loss harvesting. This is where you sell your holdings that are trading at a loss in order to offset any realized gains you have incurred. These are two fairly simple tax-reduction methods that you wouldn’t be able to take advantage of if all of your money was tied up in a target-date fund.
The decision of whether or not to buy a target-date fund doesn’t have to be an all-or-nothing question. There’s nothing stopping someone from buying one of these funds with some of their money and then managing the rest on their own, which could be a nice compromise. Regardless of what you decide, make sure to do a little bit of homework before you invest so you know what you’re getting yourself into.
Monument Wealth Management, LLC, is a registered investment advisor. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing.
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