“Will you outlive your money or will your money outlive you?” That’s it. That’s the essential question you need to answer. It’s ok if you can’t answer it or don’t know where to start, that’s why we’re here.
This is where planning and providing each of your accounts a job description (as we discussed earlier) really pays off bigtime. Timing on first use of your investments and when you plan to use your accounts will influence how their invested. It also may also come as a surprise that selecting investments in target date funds based on when you want to retire may create more risk to your planning then you realize.
Target date funds are wildly popular in many employer 401k plans including Thrifts savings plans. The design of a target date mutual fund is a combination of what is considered “riskier” investments with “safer” investments. Investments in companies of all sizes and geographic location are commonly referred to as equities. Since company values shift daily equities are “riskier” than other less price sensitive investments. These other investments are deemed “safer” as they are more liquid. Examples include fixed income, bonds, and certificates of deposit.
Investing in hundreds or thousands of equities in your portfolio provides the ability to participate in their growth and contractions overtime. Equities also may pay dividends which may be reinvested or taken as income. Increase in value over decades and potential dividends paid offer the opportunity to pay for things as life gets more expensive.
Target date mutual funds operate by automatically liquidating equities each year you progress towards your retirement date. The liquidated proceeds are then invested into “safer” investments mentioned above. Year by year you are liquidating investments that may keep pace with a rising cost of life and purchasing more investments that likely can’t keep up pace with rising costs.
Holding some cash is important to your plan. We’ll discuss this further in upcoming posts. “Some” cash being the key and making sure the cash has a purpose. When sixty percent or more of your investments is in cash problems are created from a planning perspective.
Safer, cash-like investments, are just that – safer – because there is less risk. When there is less risk, there is also a reduced likelihood of long term growth that keeps pace or exceeds the rising cost of life. This rising cost of life is also known as inflation. A successful retirement includes that ability to continue to make essential and discretionary purchases overtime as costs rise without running out of money. Using historical rates of return you cannot invest in what seem like safer investments like bonds and fixed income and assume your monies will keep pace with rising costs and last for decades.
Selecting investments without first considering this fact, endangers the longevity of your financial plan to and through retirement. With mature target date funds, sooner or later you will need to begin liquidating your lump sum of money and that’s when “you’re cooked like a Thanksgiving turkey”. As you pull money out of your account to spend, live and give it will not be relevant as costs are increasing slowly (sometimes more quickly) all around you. That can become very stressful at a time in your life when you really should (and had planned to) be living and enjoying life.
If you doubt this, take a minute to read the fund description of any target date fund currently available. As you approach your X date, the mutual fund company will have a majority percentage of investments in fixed income versus equities.
With our busy schedules today our brain is looking for shortcuts and an easier answer now. When it comes to making investment decisions it is easy to follow this line of thinking even though it’s flawed. I want to retire at 60, that’s in 2030, therefore all my investments in my retirement account should be in the 2030 fund.
Ask yourself some questions. Do you really need to have a majority of your dollars invested in short term investments that generate income for decades? How does this decision impact your quality of life and longevity? What about your legacy?
We’ll discuss more about investment selection and planning next time.