Net Gains: Hands-Free Investing Through Target Funds

Jan. 2, 2008 — -- The investment world can't seem to make up its mind about target-date mutual funds.

Some studies say they are too conservative and will not provide the returns future retirees need to finance their golden years. Others say these all-in-one funds are too aggressive, delivering too much volatility in the crucial years just before retirement.

And still other studies warn too many target-date funds charge excessive fees that act as a drag on investor returns. This one I believe, but that's not unique to target-date funds. The wise investor must always be aware of outrageous costs in nearly every type of investment vehicle.

From where I sit, the target-date mutual fund is a much-needed investment option for millions of workers whose only retirement plan is a 401(k) or other similarly defined contribution plan. These workers are responsible for all investment decisions even though many lack the knowledge or interest to build a retirement portfolio.

For them a target date fund may be the perfect solution.

A target-date fund is a mutual fund constructed with a particular retirement year in mind. That retirement year is the target date and usually indicated in the fund's name. For instance, a 2030 fund is intended for somebody like me who is due to turn 65 in or around the year 2030. A 2010 fund is meant for somebody 20 years older than me; a 2050 fund for somebody 20 years younger.

Target-date funds hold a diversified mix of stocks, bonds cash and possibly other investments, allocated in a way appropriate for the intended age group. For the youngest workers, target-date funds start out invested almost exclusively in stocks -- both domestic and international. Over time, as the target date approaches, the investment mix shifts to a more conservative one, shedding stocks little by little and picking up more bonds and cash.

Typically, they are offered in employer-sponsored retirement plans, but can be purchased by individuals, most often in an IRA.

In most cases, target-date funds are made up of various individual funds operated by the mutual-fund family that sets them up. For instance, Fidelity's Freedom Funds own only other Fidelity funds, and T. Rowe Price's Retirement Funds own strictly other T. Rowe Price funds.

Regardless of who runs them, target-date funds are meant to be an all-in-one investment solution.

In October, the Department of Labor designated target-date funds as acceptable default investments for 401(k) plans and other similar retirement savings plans that automatically enroll workers. As a result of that designation, target-date funds are only going to get more popular and may come to dominate retirement investing in the years and decades ahead.

Chances are if your 401(k) or 403(b) plan does not yet offer a menu of target-date fund options, it will soon.

Many financial planners dismiss target-date funds as overly simplistic and unable to meet the unique needs of particular individuals. True enough, I say. Target-date funds paint with a broad brush and can't handle the fine detail. But in my view they are appropriate and needed for many retirement savers.

When might a target-date fund be right for you?

First, when you are gripped with uncertainty. The truth is many retirement savers are overwhelmed by choice and can't make up their minds. Quite often, I see clients who when forced to make a decision seize up and put their money in a safe money market or bank CD. This tends to happen when somebody must roll over funds from an employer-sponsored plan into an IRA.

The problem is that due to inertia this money is likely to sit too long in that low-yielding account and not earn the returns it should over the long haul.

Second, if you are in your 20s or 30s, a low-cost target date fund could be the perfect solution. At those ages, an individualized portfolio is not critical and maybe even unnecessary. Rather the most important factors are that you are putting aside money, it is invested for the long term and it is diversified among different types of investments.

It is when investors grow older -- in their 40s, 50s and 60s -- that a customized portfolio constructed with the help of a qualified adviser is most needed. At those ages, you're losing out on the benefits of time that younger investors enjoy and most need an investment mix suited to your individual circumstances.

Third, if your access to professional financial advice is limited, a target-date fund may be the right choice. The truth is that most paid financial help is out of reach for low-income workers and even many middle income workers.

Let me say that I do believe many do-it-yourself investors are quite capable of constructing and managing their portfolios. With a little interest and a little reading, most folks can learn the basics of sound investing. The fact is, however, that many workers will never learn enough about investing to do it themselves.

In such cases, I say give them a target-date fund.

Finally, if you decide a target-date fund may be right for you, be sure to check out a couple things first. Study the expenses charged by the fund. In the ideal world, they will be less than 1 percent. If not, compare them to other funds in your retirement plan. If the target-date funds offered are significantly higher in cost than the others, you may want to try constructing your own portfolio.

Also, before investing, check out the asset allocation of the particular target-date fund you're considering. No two mutual fund families use the same asset allocations in their target-date funds. You may want to move up or down the target-date scale, depending on your individual tolerance for investment risk.

But whatever you do, make sure you're taking part in your retirement savings plan. Your golden years depend upon it.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com