Investors Now Customizing their Target Date Funds
Target date funds are a fairly new concept where people purchase a fund which is targeted toward when they plan on retiring. Does it make sense to customize this?
When you are saving for retirement and don’t want to actively manage your retirement money, which very few investors are up for, turning your money over to someone else becomes the only possible choice. Since you’re not going to be doing any of the work here, someone has to.
This is the reason why mutual funds have grown so much in popularity, and while they have some shortcomings compared to how we might want to do this ourselves if we knew what we were doing or could commit to achieving at least a modest level of understanding of how to invest, mutual funds at least open the door for us to just let someone else or indexes determine our fates.
Ideally, what we would be doing is managing our own portfolios, and anything else that we do, short of hiring a professional to do this for us, is going to fall short of the ideal. Professional money management may at least give our situation the attention it deserves but the fees for this are high, as are the minimums, and your money manager may not even have that good of an idea of what he or she is doing.
The next level down from this is to invest in a hedge fund, which doesn’t suffer from the same regulatory restraints that mutual funds do, but they really lack the ability to manage your money as well as you could due to your being herded into huge barns essentially, and it takes time and expense to move the herd to different barns.
Your income or wealth needs to be high enough to qualify to invest in a hedge fund though, and even though hedge funds have significant advantages in the way they can manage risk over mutual funds, for whatever reason, the great majority of investors are kept out.
As opposed to all the other ways we can invest, mutual funds do not have any real way to manage risk, because they are committed to taking long positions in whatever the fund is designed to hold and can’t even lay low in cash because they are also required to seek to be fully invested.
We could seek to manage this risk ourselves, and these days, we could even go with the younger brother of mutual funds, called exchange traded funds or ETFs for short, but this does require at least some knowledge of how to manage investment risk, and just knowing how to place orders is far from enough.
We’re steered well away from such things by the industry, and if everyone went off on their own and looked to manage their own risk, this would serve to make markets massively volatile and greatly increase the amount of skill needed to manage our investments well.
It’s not hard to imagine how this would happen if we think about it. As markets move down, very few investors actually look to step aside, but if a lot more did, you would see prices fall off of the table from this enormous selling pressure. A lot of people would be caught in this spike down, which would eventually subside and come back, and unless you got out real early you are going to be left stuck.
At that point we’d be told that we should have stayed the course, and in this case unless you got out early enough and got back in, trading the move profitably in other words, that would be good advice actually. This would send us backward toward more holding, and there would be an equilibrium point reached that balanced desire to achieve better returns with the practicality of this on a mass scale.
We Shouldn’t Just Completely Ignore Risk
People aren’t so trigger happy and so few do much to time their investments, so among those who do choose to do this, there are some real opportunities to do this successfully, but not if you do not have the will or in some cases the ability. It takes a lot more discipline to time investments than most people imagine, and the most challenging part of this is to be able to act on your convictions under pressure and not second guess yourself too much, which actually excludes quite a few people.
Given that mutual funds do not manage risk nor can they, and we don’t want to time them, this leaves us with few options to at least try to do something to help ourselves. We are told that there is a good way to do this, by allocating our assets properly, and this is why advisors will interview us to discover what our objectives and tolerances are prior to recommending a certain mix.
There are three categories of assets that we may choose among, which are basically stocks, bonds, and cash. We’re supposed to get reviews periodically to adjust these ratios to keep them up to date, as we get older for instance, but not enough attention is paid to this as investors generally really don’t understand why this would be so important.
As we get closer to retirement, we certainly want to be aware of how our window is narrowing and how we have less and less time to ride out whatever valleys our investments may travel to. The less time we have to ride out these drops, the more risk we’ll be facing, and we don’t want to take on too much risk less we have to cash out when prices are beat up and see our retirement plans damaged by this.
Today’s investors really prefer to keep things as simple as possible though, and ideally not have to do anything at all, including any rebalancing, so there’s a new product that would seem perfect for them, which are called target date funds.
If you are planning on retiring in 2025, or 2030, or even 2047, you can just put your money in one of these funds that correspond to your planned year of retirement, and just keep putting your money in them until you retire.
This is becoming more popular every year with 401(k) plans and these funds now have a 21% market share of 401(k) money. While this idea only provides a minimal amount of risk management, it at least provides some, and better than you would typically get from a mutual fund salesman, because these target date funds actually have people who at least know more about asset allocation than most advisors.
Advisors will at least try to take your individual situation more into account, although most of the work goes into the original sale and they aren’t really incented to do much reevaluation. Target funds at least use ongoing evaluation, although they do use only one criterion, the investment window to the target year.
This is the most important criterion though and it is preferable to have this paid attention to properly rather than be in a situation where little is being done for you at all. Target funds can be a wise choice for many people therefore, even if it is just because other common approaches are worse.
Target Funds At Least Try to Manage the Retirement Window Better
When we look at how these funds operate, and we only need to look at ones whose target year is coming right up to see how well they actually manage risk, they actually do a pretty good job in the late stages at least, when this sort of thing matters the most.
Imagine having all of your retirement money in stocks and getting ready to retire, only to see us go through a long bear market. This is actually less of a concern nowadays as it was years ago when people invested a lot less in stock markets, and people could go away for years and even forever in some cases, causing some very long down cycles, but this is still a risk that is significant enough to warrant attention.
Many see the lack of flexibility of target funds as a con, where investors are forced to buy in to the level of aggressiveness and hedging that the fund practices, and the standard mix for the year that they are going to retire may not suit them all that well. People have different objectives, where some need to be more aggressive than others, and others may need to be less so, but a target fund is one size fits all by nature.
This does not mean that we cannot play around with these to get them to suit us better, and some people are already doing this. You do get to choose which target year you go with, and no one says that it has to be the year that you are actually going to be doing it, or that you are limited to just one of these.
If you have the need to be more aggressive, or just wish to be, you can just select a target year beyond yours, which will keep you in aggressive mode for longer. You could just buy index funds instead and cook up your own mix, but that takes work, and by going off the road with target funds, you can both let others do it and have them do it more the way you want.
Choosing several with different target years allows you to take this allocation one step further, and specify how much of your portfolio you want in various target years. While we may wonder why these people don’t just manage these allocations themselves, that does take at least a bit of knowledge as well as a bit of effort and these people just want someone else to do all of that for them, which isn’t unreasonable.
The goals among target funds can differ quite a bit though, so this must be paid attention to as well, and this does require at least a little knowledge of what these things are supposed to be doing with these targets.
There are some simple formulas out there which use your age as an input, but these formulas tend to be quite aggressive and will have people with a significant exposure to the stock market to their last dollar or last breath. Target funds tend to do a better job at dialing this down, but we also need to make sure we really are dialing it down enough, and are using the right approach as well.
Cash equivalents actually should play a much bigger role than they do, things like certificates of deposit, because they actually do hedge our money and hedging is what we want and need in retirement. If you rely on bonds instead, and many rely on bonds exclusively to hedge, you’re investing in bond funds which need to be hedged themselves at times, like right now for instance.
Bonds are less volatile than stocks though so less risk is better but if we need to limit the risk, we don’t want to be stuck in bond funds that may take years to come back, which is a real worry with buying bond funds right now given that the all-time highs that they are simply not sustainable in the time frame that hedgers typically use.
If we have enough time though, there’s no real reason to be in anything but stocks, whether you are looking to time your positions or not. Stocks do a fabulous job of building wealth over time even with just staying in them, and even though we see both good and bad times.
You just don’t want to be too exposed if it is both a bad time for the market and a time that you need to withdraw from your account, so the closer this gets, the more we need to pay attention to this. Target funds at least allow for this risk to be managed better than it usually is, and they even have the flexibility to customize them more if desired.
People often may not get a choice between target fund providers, as their employer may offer just one, but you can still pick different target dates if you wish. Some think that this is a bad idea, but if used properly, it can make something helpful even more helpful.
Editor, MarketReview.com
John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.
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