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Target Date Retirement Funds

CHICAGO — The growing number of options for the right approach to retirement planning is making the right choice quite difficult. Among the choices is a relatively new kind of mutual fund that has enjoyed strong growth over the past few years. Known as target date retirement funds, their assets have jumped from $183 billion in 2007 to $436 billion as of mid-2012, according to the Investment Company Institute. The allure of these funds is easy to understand.

A target date retirement fund is simply a mutual fund designed to alter its investment strategy as the holder nears retirement. For example, the Vanguard Target Retirement 2025 Fund is designed to appeal to someone who plans to retire in 2025 or around that time.

Following conventional wisdom, these funds generally alter their portfolios to include increasingly conservative investments as the target retirement date approaches, thus relieving the owners from rebalancing portfolios on their own. The objective is to reduce risk as retirement approaches, generally by decreasing the proportion of securities and increasing the proportion of bonds.

Instead of individual securities, target date funds are funds of funds within the same fund family. For example, Fidelity target date funds invest only in other Fidelity mutual funds.

Target date retirement funds are now available from most mutual fund families. For example, Vanguard, which calls them target retirement funds, offers a choice of funds with projected retirement dates from 2015 to 2060 in five-year increments.

If you have a defined contribution retirement plan such as a 401(k), you may already own a target date fund since many retirement account managers have made them the default allocation for their plans. In any event, you may also purchase a target date fund on your own.

The simple, all-in-one approach of these funds is proving to be an obvious attraction for investors who prefer to avoid the task of choosing individual securities and rebalancing portfolios as retirement nears. On the surface, target date retirement funds are one of those easy buy-it-and-forget-it investments. All you have to do is decide when you want to retire and buy the fund closest to that date. However, as is the case with most investments, there are complexities and risks that may not be obvious at first glance.

Surprisingly, one of the biggest problems is that many investors simply do not understand how the funds work. According to a recent study by ING, only 44% of purchasers of these funds knew that the allocation is designed to change automatically as the projected retirement date approaches. Of course, this and other important information is contained in the prospectus of every fund, but many investors do not bother to read these documents.

Another consideration is the inability of target date funds to take into consideration the needs of individual investors with widely varying wealth and other personal considerations. Changes in the funds are made solely on the basis of the passage of time and the approach of the projected retirement date. Thus, a given fund will assume the same level of risk tolerance for everyone, even though this can vary sharply among different investors. Also, in many cases, target date funds carry higher management fees than other investment options.

Another difference is the philosophical approach of different fund managers and fund families. At the same moment of time from projected retirement, one fund manager may allocate a much different proportion of stocks and bonds than another. This is largely due to differing opinions on the importance of equity investments in maintaining better returns vs. bonds in producing income.

Because these funds are relatively new, they don’t yet have long-term track records, making them difficult to evaluate. For example, they can’t be compared to one of the equity indexes such as the S&P 500 because they contain both equity and fixed-income investments.

In theory, at least, it’s possible to create your own target date retirement fund since most commercially available target date funds are merely funds composed of other funds. Of course, that would require determining your own allocation between stocks and bonds and deciding for yourself on how that allocation should be changed as retirement approaches. For many people, that depth of personal involvement would likely offset the basic appeal of commercially available funds.

Despite these apparent disadvantages, the popularity of target date retirement funds continues to grow. As managing a personal portfolio becomes more and more complex, the idea of buying a fund designed to take your own retirement date into consideration without any personal involvement has an understandable appeal. For anyone who lacks the time or interest in managing a portfolio, investing in a single mutual fund rather than many can be easier and less stressful.

As with any form of investment, however, it’s important to do your own research before deciding whether buying a target date retirement fund will be the right choice for you. Before investing in any fund, start by reading the prospectus.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.

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Have a question or comment? E-mail our editor Dave Davis at [email protected] .