If you have a retirement plan at work, you likely have access to a target fund. It’s a compelling and simple idea. Just think about your planned retirement year and then select the appropriate target fund. Consider the situation of James, who is 52 years old and planning to retire at 65. James could invest his 401(k) account in a 2035 target retirement fund. By making that one decision, he’s investing in a diversified portfolio of US stocks, international stocks, and bonds. As the fund’s target date approaches, the fund manager will shift more into safer bonds and away from riskier stocks.
There’s a lot to like about targeted pension funds. They allow workers to avoid sifting through a long list of investment decisions. In addition, employers can automatically select a target fund for new employees. In the past, it was common to use a standard asset with less potential for long-term growth, such as a B. a stable value fund. Target funds allow employers to invest new hires in a diversified fund that matches their expected retirement dates. While target funds have many advantages, there are some shortcomings that you should understand before using them.
Avoid taxable accounts. For the most part, target funds are best reserved for tax-deferred accounts like traditional IRAs, Roth IRAs, and 401(k) plans. They generally don’t work as well in taxable accounts with no pension plans. First, target funds almost always use taxable bonds as part of their investment mix, with no tax-exempt bond options available. For higher-income earners, this could expose them to higher taxation.
Another problem is that target funds can generate surprising taxable distributions. A notable example is the Vanguard Target Retirement 2035 and 2040 funds, which spun off about 15% of its assets in capital gains over the past year. If you invested $200,000 in one of these funds in a nonretirement account, you would be paying taxes on about $30,000 in capital gains even if you didn’t withdraw a penny from your account.
Look under the hood. You’d think there would be broad consensus as to what percentage of stock a person retiring in any given year should own. But if you compare target funds from different managers, you can see clear differences. Another development to watch is that some target funds are now looking beyond traditional investments. Vanguard has indicated that it plans to add private equity investments to its target funds. Private equity is an asset class where private companies are bought and sold by a fund. It may involve higher risks and fees than publicly traded stocks. Finally, you should not assume that a target fund has low expenses. Although there are target funds with annual fees of less than 0.1%, some cost more than seven times as much. With target funds, one thing is clear: know what you are buying
One size doesn’t fit all. One assumption built into the target pension fund concept is obvious but often not discussed. Not everyone with the same planned retirement year should have the same investment strategy. It also doesn’t matter the larger question of how much decline in your portfolio you can tolerate before you’re tempted to exit. Investors may unknowingly invest in a target fund that is 80% invested in stocks. You may not be prepared for the volatility that will accompany it. They might only realize they’re taking more risk than they should when it’s too late, prompting them to sell when they’ve already suffered a loss.
David Gardner is a Certified Financial Planner with Mercer Advisors and practices in Boulder County. The opinions expressed by the author are his own and are not intended to constitute specific financial, accounting or tax advice. They reflect the author’s assessment at the time of publication and are subject to change.