As a financial planner, I see a lot of misguided investors, and this one was no different. I recently talked with an investor who had several target-date funds in her IRA. She rolled her investments from an old 401(k) into an IRA. Furthermore, she selected three target-date funds that had different retirement dates: a 2025 fund to coincide with when she would reach age 65, and then both a 2030 and 2035 fund to “keep her more aggressively invested.”
Target-date funds have grown in popularity as options in 401(k)s and other company-sponsored retirement plans. With increased fiduciary duty placed on plan sponsors, plans needed a default investment for participants that enrolled but never allocated their investment. Target-date funds filled this void. Typically, the year closely corresponds to the year the investor should reach the retirement age of 65. The investment allocation inside the target-date fund adjusts between stocks, bonds, and cash equivalents, growing more conservative as the specified date gets closer. These funds are sold as a “one-size-fits-all” investment. While they are a better default than a balanced fund or money-market fund, they still may not be the best option in your 401(k).
Considering someone in their mid-20s with an investment horizon of 40 years or more, I would recommend the investor allocate 100 percent to equities, with exposure to classes like Small- and Mid-Cap stocks and emerging markets, as a younger investor may be able to ride out any downturns in the market. However, looking at a typical target-date fund for 2060, you may find that it is more conservative with an allocation in bond funds and an equity lean toward Large-Cap stocks.
In contrast, an investor in their 60s who is in a 2025 target-date fund might find that their underlying investments are predominantly bonds. How do you know if that target-date fund investment fulfills your liquidity needs? The fund only considers your age, not any other factors that should affect your overall allocation.
An investor’s allocation should be reflective of his or her liquidity needs rather than a formula. For someone who is 60, retirement may be five or 10 years away. The cornerstone of the financial plan is determining your spending needs and setting that money aside. This has nothing to do with age or current income — it has everything to do with how much an investor spends each year. A plan based on the Ten Year Rule would provide liquidity through fixed-income investments for 10 years, allowing the remainder of the portfolio to be invested for growth.
Furthermore, with this example situation, she held her investments in an IRA, which, unlike a 401(k), isn’t limited to specific funds. For her liquidity needs, she could invest in higher quality individual bonds or CDs rather than the underlying bond funds found in many target-date funds. This would give her more principal protection than a bond fund. When you own a pool of bonds that are constantly maturing, the value of the bond fund is based on the market value of the bonds in the portfolio at any given time; therefore, you have no idea what the value of your investment will be when you need to sell. She could also keep her growth portion in individual stocks that would allow her to diversify and potentially pay less in fees.
While target-date funds may work for a younger investor who has no intention of allocating their 401(k) contributions, they don’t often work for someone approaching retirement.