: What are target-date funds and how do they work?

0 25

Target-date funds are a popular investing vehicle for those saving for retirement, and are a staple in many 401(k) plans. They have some advantages, but also have some negatives as well. 

What is a target-date fund? 

A target-date fund, or TDF, is a lifestyle fund that is invested toward a target retirement date. They are generally a collection of mutual funds of the fund company offering the TDF. There are also some target date ETFs. The manager will allocate the underlying mutual funds in line with the time remaining until the target date. 

Among the largest target-date fund families are Vanguard, Fidelity, T. Rowe Price and the American funds. These and other fund families offer a full menu of target dates. For example, Vanguard offers TDFs with target dates ranging from 2020 to 2065 in five year increments. 

Read: What’s happening to my 401(k)?

How do target-date funds work? 

The fund manager allocates the underlying holdings in the fund in line with the time remaining until the target date. The fund manager then reduces the allocation to stocks over time as the target date gets closer. At some point around the target date, the equity allocation levels off and stays constant in what is known as the fund’s glide path. 

Advantages of target-date funds 

Target-date funds offer a fully managed, hands-off investment option. Whether inside of a retirement plan like a 401(k) or elsewhere, target-date funds offer investors an option that takes no management on their part. In essence, target-date funds can offer a very inexpensive form of investment advice. 

Target-date funds offer built-in diversification. For retirement plan participants and other investors who are uncomfortable making their own investment decisions, target-date funds offer instant diversification within a single fund. 

Target-date funds are often the default option in 401(k) plans that use auto enrollment. Studies have shown that plans with an auto enrollment feature have significantly higher overall participation rates than those who don’t. Target-date funds can help facilitate the auto enrollment process for 401(k) sponsors. 

Disadvantages of target-date funds 

Target-date funds do not prevent investors from losing money in a stock market downturn. This should be made clear in education provided to 401(k) participants and others. Looking at recent returns for three near-dated target funds through May 30, 2022 illustrates this:

Fund

Year-to-date return

1-year return

Vanguard Target 2025

-10.82%

-7.29%

Fidelity Freedom 2025

-11.14%

-8.64%

T. Rowe Price Retirement 2025

-11.07%

-7.60%

These are funds that are conceivably geared toward investors who will be retiring in about three years. Note that during the financial crisis of 2008 we also saw losses in near-dated target-date funds as well. It’s important for investors considering a target-date fund to understand that the fund’s performance will be a function of the allocation of the underlying funds and the performance of the financial markets. Nothing is guaranteed. 

These are one-size-fits all funds. They make the assumption that every investor of a similar age has similar investments needs and has a similar risk profile. Of course this is not the case. 

Expenses can get high in some target date families. The expenses of the funds can vary widely. In some families the composite expense ratio is simply the prorated expense ratios of the underlying funds. This is the case with Vanguard’s target-date fund series with ultralow expense ratios of 0.08% for each of these funds. 

In other cases there might be a fund management fee in addition to the rolled up expenses of the underlying mutual funds. Additionally, the funds that comprise the target-date fund might have their own high expense ratios. 

Points to keep in mind 

Investors are free to invest in a fund with the target date of their choosing. They are not restricted to the fund with the target date nearest their normal retirement date. This allows them to choose a fund that is either more or less aggressively invested based on their needs and risk tolerance.

Target-date funds are portrayed as retirement funds but they can be used as an investment for any purpose an investor chooses. They are typically available in taxable brokerage accounts as well as IRAs and workplace retirement accounts like a 401(k).

The target-date fund glide path will vary by target-date fund family. Some funds go into glide path mode on or near the target date. These funds are “to’ in terms of their glide path. Other target date families go into their glide path at a later point, these funds are considered to be “through” retirement.

If you are using a target-date fund combined with other types of investments such as other mutual funds, ETFs or other investments, it’s important to ensure that your overall asset allocation is appropriate for your situation. 

Target-date funds can serve as a one-stop investment option for retirement plan participants and other investors. As with any other investment, it’s important to understand how the target-date fund invests your money. These funds offer a number of advantages, but they are also subject to risk like any other investment.

Leave A Reply

Your email address will not be published.