Should You Use Target Date Funds?

March 6, 2016

If you work for a company that gives you the opportunity to participate in a defined contribution plan (think 401k or 403b), then you probably have access to target date funds.  Target date funds are essentially funds that shift their asset allocation from aggressive (more stocks) to conservative (more bonds) as you approach retirement.  While they do have some downsides, which I’ll discuss later, the concept behind them is actually quite economically sound.

 

As an investor, you have both human capital and financial capital.  Human capital is essentially your ability to earn money.  Financial capital is already earned money that you have saved up.  At the beginning of your career, you are at your highest level of human capital because you have the greatest potential to earn money (the rest of your career) and your lowest level of financial capital unless you have inherited money.  As you near retirement your human capital decreases because you have less and less time to earn money, but your financial capital is hopefully at its peak meaning your savings are the highest they’ve ever been.  Thus, the two types of capital largely have an inverse relationship for most individuals (again excepting those who have inherited at a young age).

 

These two type of capital can be thought of as two types of assets each with its own set of risks.  The risk to human capital is that you may be fired or disabled while working, in which case you wouldn’t be able to work and would need to turn to your financial capital – your savings – to live off of.  The risk to financial savings is that you run out during retirement and have to return to work (yikes!).  These are both very real risks and should be hedged accordingly.  To hedge the risk to human capital, it’s important to be saving and, in some instances, you may want to consider life insurance.  To hedge the risks to financial capital, we need to balance it against our ability to keep working.  This is where the target date concept comes in.

 

At the onset of your career, you have a lot of human capital and a long ways to go to earn it.  If something happens in the market you have plenty of time to recoup your losses which puts you in a position to be more aggressive with your investments.  As you approach retirement and your human capital decreases, you have less time to recoup from catastrophic events which should drive your portfolio to be more conservative.  Because target date funds slowly adjust their allocation over time, at first glance they appear to be a surefire way to provide for this need.  However, target date funds are a lot like automated assembly lines – they work great for the basics, but aren’t easily adjusted for specific scenarios.  If something unexpected were to occur, the target date fund is not going to adjust.  Likewise, target date funds don’t consider your whole situation, but rather only basic variables such as your current age and years until retirement.  When it comes to the risks associated with your ability to earn money and your ability to retire with enough saved up, the ideal portfolio is one that matches the split between aggressive and conservative assets with your specific situation, keeping in mind outside forms of insurance such as life or disability insurance.  If you’d like to learn more about what asset allocation is right for you and your situation feel free to give one of our advisors a call today.  We’re always happy to help.

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