Retirement savers have, for forever and a day, been challenged by how to reasonably invest their savings. 401(k)s and IRAs have been the primary savings vehicles people have used over the past 35 years or so. But simply having access to these types of savings accounts is where the challenges begin.
Prior to the 1970s, when both of those were introduced, most working people relied on a company pension, if it was offered. For those who had a pension, it was perfectly simple. People worked for the same company for most or all of their working years, and then they had a decent stipend to supplement their Social Security and any other savings in retirement. People had no input or obligations as to how the money was invested. All the nitty-gritty of how their pension money was invested was the employer’s pension fund manager’s responsibility. Which is the way it should be.
With the advent of the 401(k), which became a replacement for pensions, savers were in a whole new ball game, one that put the onus for managing their retirement dollars on the workers’ shoulders. While 401(k)s and IRAs gave workers new ways to save and lots of autonomy, they were now expected to create and manage investment portfolios for themselves.
To put it mildly, most people are not well suited to this type of endeavor. We are emotional, and lack important basic knowledge. People will routinely take more risk than they recognize, and turn tail and run when things get dicey. We will put too much in low-risk bonds and miss out on returns that will help us enjoy retirement. We will make frequent, and often wrong-footed, changes, at precisely the wrong time. We will haphazardly pick a bunch of funds a long time ago and simply forget what we actually chose. Or, heaven forbid, load up on our employer’s company stock (I see you, GE). It’s understandable, because managing investments requires skills most people don’t have.
Enter the Target Date Fund. A TDF is an investment vehicle that is essentially a managed portfolio of stocks, bonds, and cash. The date in the name refers to when you plan to retire. So if you were 20 years away from retirement, a fund with a date of 2040 would be where to start looking. The farther away from retirement you are, the greater the amount of stock in the portfolio. As time passes and retirement gets closer, risk goes down by changing the mix of investments to favor more conservative bonds. All of which makes a lot of sense. This is prudent investment management.
So a TDF goes a long way to simplifying and strengthening the process of retirement investing. A person simply needs to pick a reasonable timeline, contribute, and stick with the program. If the markets behave the way they have historically, we should expect reasonable returns based on what the markets can give us. But they aren’t perfect.
The mix of investments can vary quite a bit. Compare TDFs from three of the largest TDF providers: Fidelity, T. Rowe Price and Vanguard. For their year 2035 funds, their stock investments are as follows: Fidelity — almost 86 percent stock, T. Rowe — almost 77 percent stock, Vanguard — a little bit more than 77 percent in stocks. So Fidelity is more aggressive than its competitors, and that means you may be taking more risk than you appreciate.
Costs vary too. Fidelity and T. Rowe have costs of approximately 0.7 percent, while Vanguard is a low 0.14 percent. This may not be in your control, at least for a 401(k) where the plan sponsor picks the funds in the plan, but certainly gives people choices in things like IRAs. So more than anything, as always, be aware what your choices mean.
It’s a solid tool for those who need to have a plan on how to invest their retirement savings. But is it effective? It is from a theoretical standpoint, in that it is doing what most people are not able to do for themselves. But I would argue it is also effective from a behavioral standpoint, too. And it is our behavior, or lack thereof, that decides our success or failure in meeting our goals.
When people don’t have to make decisions on a regular basis regarding their investments, they can let the investments work without much thought or fuss. And that’s incredibly important. Most people don’t stick with an investment plan for long periods of time. The more decisions we have to make, the greater the potential for things going wrong. Possibly very wrong.
So making just one decision, which date should be chosen, allows us to adequately address our situation. That allows us to move on to other important things in our lives. And the knowledge that your money is being prudently managed can decrease stress and anxiety when things are challenging and when mistakes happen. So a TDF actually becomes a reinforcing element to good behavior and the right temperament in achieving your retirement goals.
And temperament is the most important, yet most overlooked trait for investing success. Most people think this success belongs to the overtly intelligent folks, which is to say folks with impressive degrees and important-sounding jobs. It’s not. Without the discipline and commitment to a long-term plan, those otherwise “intelligent folks” will still make the mistakes that harm their success, intelligence aside. I’ve seen it hundreds of times. Using a TDF is a sound way to address your situation and help you learn the right temperament.
John Kageleiry is a business writer and financial planner. Have a question for “Finance 101”? Email it to firstname.lastname@example.org.