2012: End of the World? Or the End of Your Target-Date Fund? (Part 1/3)

The end-of-the-world blockbuster movie 2012 opened in record-setting style, earning more than $225 million globally in its first weekend in theaters. But despite thousands of web sites that all seem to agree that December 2012 really will be the end of the world, here at Tonka Beans we’re pretty sure it won’t be. Assuming we’re right, then you’ll need to make sure your target-date fund outlasts 2012 and manages to do for you what the movie seemed to do for Sony Pictures: pay a return on investment. (Maybe you’ve already been burned when many target-date funds had a meltdown in the financial crisis of 2008!)

But I’m getting ahead of myself – before we start to talk about how to choose a good target-date fund, we need to lay out the basics first. So in Part 1 of this three-part series on target-date funds we’ll review what they actually are, in Part 2 we’ll talk about why it’s going to be difficult to avoid target-date funds, and then in Part 3 we’ll discuss how to be smart about investing in them.

Target-date funds are mutual funds, so we’ll assume you’ve already read our primer on Mutual Funds and start from there.

“Asset Allocation” Funds

The majority of mutual funds can be classified as either stock funds or bond funds, and whether they’re index funds or actively managed funds they remain stock or bond funds (and they have to stay that way because their prospectus limits what they can invest in).

Then there are some mutual funds that mix stock and bond holdings in the same portfolio and these are called “blend” or “asset allocation” funds. But here again, these asset allocation funds will generally keep the ratio of stock to bond holdings in a very limited range (and you guessed it: these funds have prospectuses that outline exactly what the range can be). In fact, in the early days when asset allocation funds were introduced, many were even named after that stock to bond ratio (e.g., “Moderate Asset Allocation Fund 40/60” or “Aggressive Allocation Fund 70/30”).

In theory, the whole point of asset allocation funds was to make it easier for investors to diversify. Instead of trying to figure out a portfolio of multiple stock and bond funds, the idea is that you can get “instant” diversification by putting your money in one fund that does the work of splitting it up between stocks and bonds for you.

“Target-Date” Funds

But then investors and brokers and fund companies all started to figure out that just because you invested in one fund, your work wasn’t done. Why? Because we all get older. People started to understand that an asset allocation fund that might be a great fit for a 20-year old might not make quite as much sense when she becomes a 25-year-old and then a 30-year-old and so on… and therefore she’d need to keep changing which asset allocation fund she was invested in.

So, voila! Over the past few years we’ve seen the introduction of a lot of target-date funds. The big difference with target-date funds is that these are asset allocation products that are much more flexible than all the other types of funds. In fact, they are designed with the intent to change the ratio of stock to bond holdings over time. How much time depends on which fund you invest in, but they’re generally geared for retirement. As an example, a 39-year-old hoping to retire at age 65 in the year 2035 would invest in a 2035 fund, while a 29-year-old with the same projected retirement age would invest in a 2045 fund.

Sounds easy, right? These target-date funds are a perfect, one-stop solution! Well, before you blithely toss your skepticism out the window, I can tell you that the government seems to think so… and we all know the government is always right. Right?

Of course I haven’t told you the whole story yet, and that’s what we’ll dig into in Part 2….