One option for building a retirement plan that is the frequently touted but rarely understood, are target date funds. Target date funds could be a significant ingredient to saving for retirement, but what are they really?
Target date mutual funds are a professionally managed investment tool with a mix of stocks, bonds and other investments based on the fund’s target retirement date and the time until that date. The fund’s allocation* to riskier investments is gradually reduced as the target date draws closer.
Most target date funds are structured as a fund of funds. In other words, the fund manager invests the fund’s assets in shares of other mutual funds based on the target date fund’s desired asset allocation.*
Target date funds are a popular choice in 401(k) plans and may be used as the default investment option for those employees who don’t make their investment choice.
When do target funds make sense?*
Since target date funds are professionally managed, they can be a solid option for investors who may not be comfortable choosing and managing their own investments.
For younger investors who may be starting out, a target date fund can offer broad diversification where they might not otherwise have enough assets to purchase the several different investments that might be required to be truly diversified.
For older investors, a target date fund can also make sense for many of the same reasons. They may have gotten a late start on investing and don’t have a portfolio of sufficient size to diversify on their own. Or they just may not be comfortable choosing and managing their own investments.
Choosing a target date fund*
To or through retirement? Target date funds reach their most conservative allocation, often referred to as the glidepath, at different points in time. For some fund families, the glidepath starts at the target date, while for others it may extend out a number of years past this date.
Target date funds all have a glidepath into retirement. This means that as the target date of the fund approaches, which generally equates to someone who is aged 65 (or at retirement age), the fund allocation to riskier investments levels off. The actual age where this happens can vary widely from target date family to family.
The glidepath is a good feature as long as you clearly understand when the glidepath begins and what that allocation to equities will be. Is it appropriate to where you want to be invested at that stage of your life? Is the allocation too aggressive or perhaps too conservative for you at the point in time?
Understand the fund’s underlying holdings*. As previously mentioned, most target date funds are funds of other mutual funds. Be sure to understand the funds being used in the target date fund. If you are using the target date fund in conjunction with other investments it is critical that you fully understand how these underlying investments interact with your other holdings and how they impact your overall asset allocation.
Along this same theme, be sure you understand the manager’s overall investment allocation and strategy and be sure that you are comfortable with it. Some experts suggest not mixing a managed allocation product like a target date fund with a menu of other investments for fear that the investor’s asset allocation will be impacted without the investor realizing it.
You aren’t tied to a specific target date*. Target date funds are designed to help investors stay on the correct path until their anticipated retirement date, meaning they may be encouraged to invest in a target date fund with a target date close to their retirement age (generally assumed to be age 65). There is no rule saying that an investor must invest in a fund with a target date that corresponds to that date however.
Investors are free to choose any target date fund that they feel is appropriate for their situation. You don’t have to choose the fund with the target date closest to your anticipated retirement, you can choose the fund that best fits your desired allocation and risk profile. You can choose a fund closer in time (less risky) or further out (more-risky).
For example, if the target date fund closest to your anticipated retirement is a 2030 fund, but you are looking for a more aggressively invested fund, than you might pick a 2040 or perhaps even a 2050 target date fund. Likewise, if you are looking for a less aggressive investment choice, consider the target date fund closest to your anticipated retirement date.
Target date funds are a popular investment option in many 401(k) plans and similar employer-sponsored retirement plans. In some plans, the target date fund closest to an employee’s anticipated retirement date is the default investment if they fail to make their own investment choices.
Expenses matter. As with any mutual fund, you will want to be sure to understand the expenses associated with any target date fund that you are considering. It’s important to understand the expense ratio of the target date fund and what these expenses include. For many target date funds, the expense ratio is the weighted average composite expense ratios of the underlying funds. In other cases, the target date fund’s expenses include a management fee on top of the rolled-up expense ratios of the underlying funds.
When considering target date funds with the same target date from different fund families, remember that they may differ greatly even though they have the same target date. For example, a target date 2030 fund from three different fund families might have very different asset allocations, glidepaths and may differ in other ways.
The benefits of target date funds
Target date funds offer a professionally managed investment option that might be right for some investors. They offer broad diversification and an asset allocation that reduces the level of riskier investments over time as the fund’s target date gets nearer. They could be a great option for those investors who are not comfortable making their own investment choices.
Target date funds do require a bit of analysis to understand how the fund will invest your money and the level of expenses. Like any investment, investors are wise to understand how the fund will be investing your money.
*Diversification and asset allocation do not guarantee better performance and cannot eliminate the risk of investment loss.