Target-date funds (TDFs), which are frequently described as a “set it and forget it” approach to investing for retirement, have grown in popularity during the past two decades. Below are ten “need to knows” about investing in TDFs:
How They Work
Target-date funds hold a mix of stocks, bonds, and/or cash equivalent assets and gradually become more conservative (read: a smaller percentage of stock in the fund portfolio) and income-oriented as the “target date” (e.g., 2050) approaches and, once it is reached, going forward. The mix of securities within a TDF changes over time.
Where They Are Used
Target-date funds are a frequent “menu” option for workers to select in tax-deferred employer retirement savings plans.
For example, federal government workers have “L Funds” in the Thrift Savings Plan. TDFs are also a popular “default option” for retirement plans where workers are enrolled automatically unless they “opt out.”
TDFs are built on the long-standing assumption that investors should have less stock and more fixed-income securities in their portfolio as they get closer to retirement age. Asset allocation changes are made automatically for them. The target dates in TDFs are generally provided in five- or ten-year intervals (e.g., 2030, 2035, 2040, etc.).
TDF Glide Paths
“Glide path” is the planned changes in asset class (e.g., stock and bond and cash equivalent assets like money market fund) weightings over time as a TDF approaches its target date and beyond.
Glide paths and, hence, stock and bond allocations vary among TDF providers and should be compared side-by-side for TDFs with the same target date.
More About Glide Paths
Three key elements of a TDF glidepath to compare are the initial equity allocation, the slope of the glidepath (how much and how frequently asset allocation changes), and the equity landing point. This is the date when the equity (stock)-to-fixed income ratio remains unchanged throughout the remainder of an investor’s life.
Many target-date funds are “funds of funds” that create their portfolios by investing in other mutual funds.
With these funds, investors pay two sets of expenses for the fund itself and its underlying funds.
The lower the expense ratio (expenses as a percentage of fund assets), the lower the cost to investors so they keep more of what they earn.
TDFs provide diversification across asset classes and time intervals to meet a variety of planning needs. Investors can buy TDFs in taxable or taxable or tax-deferred accounts. Many have low required minimum deposits and fund managers make all asset allocation decisions. TDFs offer a low-maintenance starting point for new investors.
As with any investment, TDFs can lose money. They also do not guarantee anyone a sufficient retirement income. TDF characteristics vary among investment companies, which can make “apples to apples” comparisons difficult.
In addition, certain glide paths may leave investors exposed to more risk than they want.
Investors planning to retire in between two TDF target dates can choose the nearest date (up or down).
For example, if planning to retire in 2042, they might select a 2040 TDF or a 2045. If someone is a conservative investor, they might decide to “go shorter” (2040), while a more aggressive investor might “go longer” (2045 or beyond).
TDF Selection Criteria
Like any mutual fund, there are three key factors to consider when selecting a TDF: 1. the fund’s composition and investment style, 2. historical performance, and 3. fees and expense ratio.
Small differences in fees can translate into large differences in returns over time.
For additional information, check out this webpage from the U.S. Securities and Exchange Commission.