How to best save and invest for retirement should be a careful consideration. One increasingly popular investment option is target date funds which may also be referred to as life-cycle funds. They are offered by almost 90% of employer-sponsored contribution plans such as 401(k) plans. These funds are designed to manage the risk of investment. The investor will pick a fund that has a target year which is closest to the anticipated retirement year.
For example, a person who plans to retire in 2050 would choose a 2050 fund. As the individual moves toward the retirement target date, the fund will reduce the risk by changing the investments in the fund. The funds will change from higher-risk stocks to lower-risk bonds. However, all people investing in these funds should know that target date funds are not without their own risks even when the target date has been reached.
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Target date funds are structured as a mutual fund. The particular investments in a mutual fund are determined by its objectives which are disclosed in the prospectus. Most of these target date funds will be invested in other mutual funds than in individual securities. What exactly are the benefits and disadvantages of these funds though? There are pros and cons of target date funds which each investor should consider before making an informed decision.
Want to get a firm understanding of a mutual fund? Read this short article.
Benefits of Target Date Funds
1. Easy to Use
What makes this attractive to investors is that you only have to have a single investment. While some people may enjoy doing their own research and picking out individual funds, many investors simply find that they don’t have the time to do this or have interest in doing so. A target date fund is not a single fund but instead a bundle of investments. The simplicity of this is what makes it attractive to many investors. To simply pick the date of retirement and matching it to the fund is the simplest process available today. While some may argue that this may not be the best portfolio available today, it is a reasonable asset allocation that is likely to allow people to meet their retirement goals.
2. Diversified Funds
One of the biggest principles when it comes to investing is the principle of diversification. This basic principle means that if one investment doesn’t do well, other investments will may up for that lack of performance. Predicting the future is simply impossible which is why a diversified portfolio allows for a wide range of future scenarios. A target date fund provides investors with a diversified investment portfolio naturally. Not only does it diversify between stocks and bonds, but it is also diversified in each other those asset classes. Individual securities in the fund can be in the thousands.
3. Reduces Investor Error
Most investors are not going to be highly invested in researching their retirement fund. They need to have a long-term approach and avoid thinking short-term since investments are going to gain and lose money in the short term. The biggest risk to many retirement portfolios is the investor themselves. Since a diversified portfolio reduces volatility of the overall investment, it’s easier for investments to stick with their plan and not pull their money out, even in a market downturn. The fund controls all aspects of the investment except for the money that’s actually put into the fund. The target fund helps to give investors peace of mind and will help to avoid making mistakes in the process.
Disadvantages of Target Date Funds
Of course, there can also be downsides to these funds. To get an idea of what would make this a poor choice, consider these downsides.
1. Loss of Control
Just like this is a main advantage, it’s also a primary disadvantage. Sometimes it can be great to not be in control but that also means that investment savvy investors can’t select their investments. They can’t select asset allocation or glide path. The professional manager is in charge of that. For many investors though, they can research the fund closer and select the one that they want by the asset allocation. This means that while it may be more work for those that want control, it is possible. For the non-savvy investor though, this can be a disadvantage and end up costing them in the long run.
First time hearing about the term glide path? Want to learn more about it? Read here.
2. Risk Tolerance Mismatch
The professional manager on the target date fund makes the decision on how much risk to take on before retirement. This could mean that the fund ends up being less risky than desirable or vice versa. For example, most funds start with 90% stocks and stay at that level for years. That’s a fairly aggressive investment and may be more aggressive than what other investors would want to experience. Since the investors can’t choose their own risk level, they may find that the manager doesn’t align with their own goals. Or the more likely scenario is the investor doesn’t even release the misalignment. Ignorance is probably more likely to happen because most folks don’t have the time to sit down at night after work and analyze their target date fund.
3. More Expensive
What may be surprising to some investors is that a target date fund is more expensive than building your own investment portfolio. However, investors such as Vanguard use a slightly more pricey investor fund instead of the cheaper Admiral share classes. This ends up with each investor paying about five or six basis points higher than if you designed the same fund using Admiral funds.
Additionally, target date funds carry a higher expense ratio. Some target date funds easily show that an additional expense is present. They stack an additional fund expense ratio on top of the underlying fund. Not all investment companies do this with their funds. This is unfortunate for investors that want to maximize building wealth, but it is the price you pay for the convenience. The convenience of just selecting one fund appropriate to your retirement year.
While the cost of a targeted date fund may not seem like much in the short-term, it can end up costing retirement savings in the long run.
Making the Investment
For many beginner investors that don’t understand investments, the benefits of a targeted date fund outweigh the consequences. While this is a viable option, each investor should have an idea of what to expect before making a final decision. For investors that are either experienced and comfortable with investments or want a more personalized approach that potentially could help you better manage risk and may reduce cost as well you will want to seek out other options.
Investors who are unsure of this choice can also decide to put a portion of their retirement in a target date fund and invest the remaining portions in other investments that meet their standards. Or better yet take the step towards working with an expert in the field that can properly understand your personal situation and tailor a portfolio to you.
This article originally appeared on WealthTender.com and was syndicated by MediaFeed.org.
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Confused about retirement accounts? Read this
Saving for retirement is an important financial task. And while there are plenty of options available, many Americans are still confused about how best to prepare for retirement.
In fact, only 34% of Americans said they were knowledgeable about independent retirement accounts, according to a recent study by the LIMRA Secure Retirement Institute. And only one in five Americans knew the 401(k) contribution limits, according to a survey by TD Ameritrade.
Educating yourself about retirement accounts like the employer-sponsored 401(k), as well as self-directed options like a traditional IRA or a Roth IRA, is a critical part of preparing for your golden years. Here’s how to decide which one is right for you.
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The first step to saving for retirement should be putting enough money in an employer sponsored 401(k) plan, if you have access to one. Take advantage of any matching employer contributions.
“If you work for a corporation that provides a 401(k) be sure to max this out, as their matching policy is ultimately equivalent to free money,” said Jared Weitz, CEO and founder United Capital Source. “This is the retirement account that offers the highest contribution value each year.”
Keep in mind 401(k) programs have some drawbacks and limitations, including administrative costs, said Samantha Anderson, a wealth manager at Budros Ruhlin Roe. In the same TD Ameritrade study, only 27% of Americans know how much in fees they are paying on their account.
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The biggest question to consider when deciding between a Roth or Traditional IRA is if you think your tax rate will be higher or lower in the future.
“Traditional IRA contributions are tax-deductible in the year they’re made, and a Roth IRA takes taxes out now, so that in the future when you withdraw money during retirement it is not taxed,” said Weitz.
If you think your tax rate will be higher during retirement, a Roth IRA is a good choice. If you expect to have a lower tax rate in retirement, the traditional IRA is likely a better choice to take advantage of the upfront tax break.
If you’re ready to start saving, check out our guide to opening an IRA.
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Roth IRAs offer more flexible early withdrawal rules and fewer restrictions for retirees. It’s also much easier to pass on a Roth IRA as inheritance, said Weitz.
There are however income limitations for contributions to a Roth IRA. The gross income for a single taxpayer is capped at $137,000 with contribution reductions starting at $122,000. For married couples filing together, income is capped at $203,000 and reductions start at $193,000.
The income maximums makes this type of account best for younger earners who are typically lower earners and have a significant amount of time until retirement, said Anderson.
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The benefits of a traditional IRA include not having to pay taxes on the money until funds are pulled out of the account, said Stephen Fletcher, a CFA with BlueSky Wealth Advisors.
“A traditional IRA is ideal for someone who needs to lower their taxable income now, and who will be able to be strategic in the way that the IRA funds are withdrawn in retirement so that the taxes paid will be as low as possible,” said Fletcher.
Don’t think you’re saving enough for retirement? Here’s how to catch up.
This article originally appeared on Policygenius and was syndicated by MediaFeed.org.
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