Target-date and age-based funds, or TDFs, have become very popular over the last several years, especially in 401(k) and college 529 plans.
Although a TDF might be a good choice for some investors, in many cases, the “one size fits all approach” might not be appropriate.
TDFs are based on “asset allocation,” a strategy aimed at achieving diversification by allocating investments across broad asset classes such as cash, stocks and bonds.
Diversification does not eliminate risk. However, it may reduce overall risk (volatility) by allocating money across different asset classes.
In the case of a TDF, the fund manager will determine the allocation and select the particular funds within that allocation, rather than you or your adviser making these choices. As you move closer to retirement (the target date) or the start of your child’s college career, the ratio of stocks to bonds declines and, correspondingly, the portfolio’s risk and return.
This is where the standardized approach of TDFs can be problematic.
The pre-determined asset allocation might not be appropriate for a particular investor. The decision of how to divvy up a portfolio between stocks and bonds should be based on many factors besides age, including how much the investors have saved, the amount of income they will need, their actual retirement or college commencement date, etc.
For example, an 18-year-old’s age-based 529 account might be invested entirely in cash. While this conservative approach can be appropriate for a student planning to withdraw all of the money right away, it could be needlessly forfeiting the returns offered by bonds (or longer-term investments) if the student is planning to spread withdrawals out over four years or more.
Investing in a TDF can have other negative consequences. In 2008, many TDF investors, including those who were planning on retiring shortly, found out the hard way their fund was overly invested in equities.
While appropriate for some, it was not so for those planning on using this money for retirement income.
While TDFs can be a good solution if used wisely, an investor should consider this strategy only if it makes sense within his or her own personal financial plan.
It is important to:
1. Understand your personal goals and objectives.
2. Know the amount of nest egg you will need for retirement or college.
3. Know the amount of income you will need from that nest egg in retirement or during college.
4. Be clear on your timeframe.
5. Understand the amount of risk you are willing to assume in order to achieve the return you need to meet your financial goals.
6. Select a fund that most closely aligns with goals and constraints, then monitor on an ongoing basis.
7. Integrate your investment strategy with your overall personal financial plan.
When it comes to investing, one size does not fit all; individual investors require individual solutions and a personal financial plan is the most effective way to determine what is right for you.
Jim Schlager will share more investing advice today on "Power Lunch," 1-2pm ET, as part of a special week-long series, "Hands-On Investing."
Jim Schlager is a partner at Moss Adams Wealth Advisors LLC.