Imagine this. You open your statement every month and decide to do an impromptu financial check up on your IRA. You go online and it takes you five to 10 minutes, at the most. You understand your investment, feel confident about your choice and confirm that you are on the right track to a successful retirement.
Or, perhaps, you look at your portfolio and decide you'd like to buy a second home in the next 10 years. You know that saving it in a regular money market account will not grow it quickly enough, but you don't know where else to put it.
What if I told you there was one type of investment that fits both these scenarios? Does it sound too good to be true? It isn't. The good news is that almost every mutual fund company offers one: target date mutual funds, also known as life cycle funds.
The main benefit of investing in a target date fund is that it increases your investing confidence because you are properly diversified and remain so year after year. I've seen many success stories over the years with a variety of investment profiles: Elizabeth, 27, who wasn't sure how to invest her Roth IRA; Kathi, 42, a self-employed business owner who was looking for an uncomplicated, yet sophisticated, tool for her SEP IRA; Eric, 32, who was evaluating the choices in his 401(k), including target date mutual funds; and Kim and Robert, a couple saving for their second home and wondering where to invest that money.
What are they?
Target date mutual funds are a type of investment that bases asset allocation on the target end date of the fund. Their greatest and strongest benefit is that they provide instant and ongoing asset allocation. They are made up of a wide variety of large-, mid-, and small-cap funds, as well as international, and bond mutual funds from the same fund family.
When Eric was picking mutual funds for his 401(k), he could have chosen only three or four mutual funds and not been exceptionally diversified. Instead, he picked,
American Century LIVESTRONG 2025
, which holds American Century Equity Growth, American Century Large Company Value, American Century Intl Growth, American Century Inflation-Adjusted Bond and American Century Emerging Markets, just to name a few. Without this choice, he would not have been invested in an inflation-adjusted bond or felt comfortable with the risk of an emerging markets mutual fund. But given that we are potentially entering a high inflationary period and he is young enough to handle a little bit of risk, these were both great choices, especially in our down market.
Every year, the fund's manager readjusts the percentages in the mutual fund categories so the fund adheres to the original asset allocation, also called a fund mix. The fund mix also changes to make the fund more conservative as you get closer to the target date of return, and that is also part of the original plan. If you did nothing, it would end up completely overweighed in one area and become too aggressive as you got closer to your target date. You can buy target date funds yourself from a mutual fund company, and they are also found on many 401(k) plans. There are more than 250 of them with over $150 billion in assets.
Your target date:
Come up with your target date. When do you want this money to be available to you? Kathi doesn't plan to retire for at least 30 years, in 2038. As end dates for almost all of these funds run every five years, she is looking at funds maturing in 2030 or 2035. Two good options for Kathi:
T. Rowe Price Retirement 2030
Barclays Global Investors 2030
. Both are great no-load (no upfront sales charge), low expense ratio (ongoing annual fee), highly rated target date mutual funds.
Since Kim and Robert have a 10-year time frame, they should stick to a target fund with an end date of 10 years or less. If they were to pick a later end date, say 20 years, their investments could be too aggressive and not provide more of the security they need for a shorter time frame. Two great funds that would help them reach their goals are
American Century LIVESTRONG 2015
Vanguard Target Retirement 2015
because they have a target date of less than 10 years and have shown returns above the current market. With market returns heading south in this economic environment, it can be hard to differentiate between mutual funds. One way to see a shining star is to check if a mutual fund has performed better than its index. These two have.
If you were investing in a group of mutual funds for 20 to 30 years out, ideally your retirement portfolio would be approximately 80% stocks and 20% bonds. For your target date retirement mutual fund, you want the same balance. When Elizabeth was looking for an investment for her Roth IRA, she knew she wanted 20% in bonds and 80% in stocks, given that she is only 27.
Fidelity Freedom 2030
reflects this desired balance, with just over 20% in bonds and cash. If she changes her mind in the next few years and opts for a marginally more conservative approach,
Schwab Target 2030
has more than 30% in bonds. These mutual funds are both no-load, low expense ratio funds that have performed above their respective indices.
What does it hold?
Not all target date mutual funds are created equal. When evaluating them, take a quick glance at their actual holdings. If you are a conservative investor, you want to make sure it isn't too risky and vice-versa.
Eric feels real estate is too risky and wanted to make sure that the funds he was considering did not own any real estate positions, like Fidelity Freedom 2030 Fund. Other potential risk areas are international (especially emerging markets) and high-yield bonds. Even though you are investing in one mutual fund, make sure you have looked at all the individual mutual funds within the target date mutual fund. This is easily found on the mutual fund's home page.
Are they all built alike?
Target date funds are only as good as the sum of their parts. There are two easy screening methods you should employ when considering which ones to buy:
1. Make sure they are rated 4 or 5 stars by Morningstar, which measures the risk of the mutual fund based on performance and fees compared with similar mutual funds. Two five-star target date mutual funds:
American Century LIVESTRONG 2035
and Schwab Target 2030.
2. Check the expense ratio, the annual fee you pay for the manager and other administrative expenses, regardless of the fund's performance. Every mutual fund has an expense ratio and you want to make sure yours is as low as possible. If Elizabeth invests $10,000 in her Roth IRA, the
Vanguard Target Retirement 2030
, which has an expense ratio of only 0.21% annually, will only cost her $21 per year, leaving the remaining $9,979 to be invested. Higher expense ratios mean less money for you. Another low expense fund is T. Rowe Price Retirement 2030, with a 0.72% expense ratio. These are two of the lowest in the industry.
If you don't have a lot of money saved and can only afford to invest $100 a month, or even a larger total sum of $3,000, investing in a target date mutual fund allows you to be instantly diversified. Since most mutual funds have a minimum investment of at least $2,500, you would not be diversified if you could only choose one regular mutual fund. You can contribute more to target date funds as you have more money, which also helps since you may not know which mutual fund category to invest in on an ongoing basis.
And even if you have $100,000, chances are you are not going to research the different categories you could invest in. This lets you take advantage of professional money management for the same cost of a regular mutual fund.
For a small-business owner like Kathi, she has been focused on growing her business, not managing her money. She invests in her SEP IRA every year based her income that year. She is especially worried with the stock market falling more than 40% this year and wonders how her target date mutual fund in her SEP IRA is doing. By visiting Morningstar.com, within minutes she sees the actual performance year-to-date and how it has performed relative to an index.
While it is down this year, her mutual fund is actually doing 5% better than the market. Even though it is only one mutual fund, she is really evaluating the performance of more than 20 mutual funds in her target date mutual fund. The likelihood of her reaching her retirement investment goals is stronger because she is able to take advantage of down and up markets and different types of investments without making the timely and intricate decisions herself.
There are, of course, a few downsides to these funds. Some companies may charge a higher expense ratio based on the idea that there are many mutual funds involved. Read the fine print! In addition, some target date funds may be too aggressively invested in terms of their bond-stock mix. Even in funds where the target date is less than 10 years, you might be taking on too much risk for that time frame. This is especially important to consider right now, when the stock market may not rebound as quickly as we want it to. Your investments should remain more conservative than originally planned. Lastly, target date mutual funds can be a little trickier to analyze given the amount of underlying mutual funds in the target date fund. This is easily solved by looking at the list of underlying mutual funds and agreeing with all the categories.
Target date funds are ideal for people just beginning to save for retirement or those who don't want to think too much about their investments but want the peace of mind of knowing they are on the right track. If you want more information, independent research firm Lipper recently published a detailed study on them. One of the mutual fund families highlighted was the Principal Funds, which offers
Principal LifeTime 2030
. While you should still do a check-up on your investments annually, you can set them on auto-pilot until your situation and asset size starts to change with a target date mutual fund.
Galia Gichon is a personal finance expert who founded Down-to-Earth Finance. With over 14 years financial experience, an MBA in finance and the author of the "My Money Matters" kit, Down-to-Earth Finance provides unbiased financial education. You can visit her at