How to Handle Target Funds for a Safe Retirement

NEW YORK (MainStreet) – Once again, investors are disturbed by lackluster performance in target-date mutual funds aimed at retirement. But part of the problem is a misunderstanding about how these funds work. They are not really meant to provide for day-to-day living expenses, which are better served by simple bank accounts and other bank holdings.

Year-end figures show that the average target-date fund just four years shy of the holder’s retirement date in 2015 lost about 0.4% in 2011, while the Standard & Poor’s 500 stock index gained 2% and a standard bond index fund gained 8%, according to Morningstar, the securities data firm.

Target-date funds have become a popular fire-and-forget approach to retirement savings, and are offered in many 401(k)s and similar plans. The investor selects a fund with a date matching his or her expected retirement year, and the fund gradually shifts more of its holdings from stocks to bonds and cash as the date approaches.

The idea is to get stocks’ big gains in the early years, when the investor has time to weather downturns, and to become more conservative in later years. But many investors were shocked by losses in 2008. Now 2011 seems like a second slap in the face.

Clearly, some target-date funds are better than others, and investors need to closely study fund’s asset-allocation strategies and fees.

But many investors apparently do not realize that even after the target date has passed, many of these funds will continue to allocate 25% or more of their portfolios to stocks. That’s to assure that the fund’s value continues to grow enough to offset inflation during a 20- or 30-year retirement period.

Even the bond portion of the fund is not risk free, as bonds can lose value when interest rates rise.

It is probably a mistake, therefore, to assume that the target-date fund will be a source of day-to-day cash after retirement begins. After all, an investor who owned individual stocks and bonds would not tap them for grocery money, either. Not if he followed standard advice.

The best way to view a target-date fund is as a headache-free asset allocation tool. Upon retirement, the investor should have cash holdings outside the target-date fund sufficient for one or two years of ordinary expenses.

Then, when conditions are right, shares of the target-date fund can be sold to replenish those cash holdings.

With today’s low interest rates, cash holdings are not very profitable. But they’re really not intended to be – that’s why your target-date fund still owns some stocks. Cash is meant to be safe and secure.

And there’s a silver lining in the low-rate cloud: You don’t have to jump through hoops looking for a great savings account or certificate of deposit. Tying your money up for a year or two will add so little to your interest earnings that there’s really no point in doing it. Just find a convenient bank and stash your money in a checking or money market account.

Then hope the stock portion of your target-date fund will produce some bigger returns in the future.