Retirement Target Funds are Designed to be a Solo Player
According to the Employee Benefit Research Institute (EBRI), 74% of 401k plans offer some kind of “target date retirement” funds. These are funds which purport to diversify your investment across asset classes based on your estimated retirement date. The further away the retirement date, the heavier the allocation to equities (stocks). As the target date draws nearer (or passes, indicating the individual may already be in retirement) the asset allocation shifts more in favor of fixed income and cash investments. The funds are supposed to be simple one stop solutions to the question of how to invest your 401k funds for retirement.
The EBRI also states that 41% of investors use the target date funds in their investment mix, and 15% of 401k assets are held in target date funds. The implication (confirmed by my observations in the field) is that many people use Target Date Funds in their 401k, but it is usually not their ONLY holding.
The problem is that mixing Target Date Funds with other investments may defeat the very purpose of the fund.
Used correctly, a Target Date Fund should usually be the only holding in your 401k. Why is this? Aren’t you supposed to diversify your holdings? Well, yes and no. Of course, diversification is important. It is not good to have all of your assets in stocks (unless you are a young and aggressive investor). Likewise, being all in cash likely won’t help you achieve your goals. Balance is important. But the Target date funds are already diversified by their very design. They split their investment dollars amongst many other mutual funds covering all major asset classes, according to how the issuing company feels that the average person retiring at that date ought to be invested. Since the fund has diversified for you – there is really no need to diversify further.
What I see people do (and supported by the EBRI statistic above) is invest a portion of their portfolio in the Target Date Fund, and then add several more investments around it. Maybe the thinking is that investing can’t really be this simple – I must have to do more! But these additional funds are unnecessary for most investors, and make sense only if you are trying to accomplish one of the following objectives:
a) You are retiring near the Target Date, but are adding stock investments because you believe you are more aggressive than the average investor your age.
b) You are retiring near the Target Date, but are adding cash / bond investments because you believe you are more conservative than the average investor your age.
c) You are much smarter than the people making the asset allocation choices at the mutual fund company in question, and are adding positions to compensate for errors in the fund’s investment strategy (Just kidding on this one).
While this can work for some investors, it is difficult to really understand how the funds you have added to the Target Date funds will impact your risk exposure. This is why mixing the Target Date funds with other investments can defeat the purpose of owning a Target Date fund in the first place.
If you feel the Target Date allocation is too aggressive or too conservative for your taste, there is a much easier solution. If you are more aggressive than the average investor of your age, then choose a Target Date fund 5 years later than your actual planned retirement. If you believe you are more conservative, choose a date 5 years sooner than your planned date. This way you can be pretty sure you have a fund which is well diversified, consistent with your retirement goal, and offering a level of risk you can live with.
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