Target-Date Funds: Does One Size Fit All?

So, you start a job and set up a 401(k). You’re asked to estimate a retirement date, so you do. This date seems far off in the future, so you don’t think too much more about it. But you should think about this: You are now likely in a target-date fund.

Ready, aim

Target-date funds, whose mix of stocks and bonds go from riskier to more conservative over time, are mutual funds or exchange-traded funds (ETFs), which are structured to grow assets in a way that is optimized for a specific time frame. The structuring of these funds addresses an investor’s capital needs at some future time—the target date. Most often, investors will use a target-date fund applied to the onset of retirement.

According to the Wall Street Journal, an estimated 40 million Americans have put at least part of their retirement money in target-date funds since the products first started hitting the market in the early 1990s. The amount of money in target-date mutual funds and target-date ETFs has now reached approximately $1.746 trillion. According to Fidelity, approximately 86% of workers from Gen Z (those born between 1997 and 2012) hold 100% of their savings in a target-date fund. If you have a 401(k) or other retirement account that invests in the market, some of your money is almost certainly in a target-date fund.

Got the time?

Target-date funds use a traditional portfolio-management methodology to focus asset allocation over the term of the fund to meet the investment return objective. Named by the year in which the investor plans to begin utilizing the assets, target-date funds are considered extremely long-term investments.

A target-date fund’s portfolio-asset-mix and degree of risk becomes more conservative as it approaches its objective target date. Higher-risk portfolio investments typically include domestic and global equities. Lower-risk portions of a target-date portfolio typically include fixed-income investments such as bonds and cash equivalents. Investors can take more risk when they’re younger, as they can weather the typical ups-and-downs of the stock market over a long-term horizon. But as investors get close to their retirement, the fund moves toward increased lower-risk (and often lower return) selections accordingly. Target-date funds can be actively managed or passively designed against indices or pre-set benchmarks.

In the mix

Typically, target-date funds include a mix of stock funds and bond funds. These can be either index funds or actively managed mutual funds. The exact mix of stocks and bonds is based partly on an investor’s age when they enter the fund and partly on when the investor plans to retire.

A fund’s portfolio managers use this predetermined time horizon to fashion their investment strategy, which is often based on traditional asset allocation models. The fund managers also use the target date to determine the degree of risk the fund is willing to undertake. Target-date portfolio managers typically readjust portfolio risk levels annually. Target-date funds create what is called a “glide path” based on this information.

Where are you going?

Most fund marketing materials show the allocation glide path—that is, the shift of assets—across the entire investment time horizon. A glide path is like an investment roadmap. The fund’s structure their glide rate to achieve the most conservative allocation closest to  the specified target date.

There are two dates the investor should keep in mind. The date of retirement from work when fresh contributions into retirement funds cease and the glide path date when the funds are drawn down or used to support the retiree’s lifestyle. Things change when the retiree can no longer make additional contributions to their of retirement funds. At this changeover, the growth of the pool is driven by investment returns not new contributions. The market risk of loss could become much more difficult to overcome. For the investor looking forward, the issue is ‘will this fund be conservatively managed from this point onward?’ This is not necessarily easy to tell based upon the glidepath you need to talk to your advisor about risk.

The principal value is not guaranteed at any time, including at the target date. Because of this risk, it’s important to know how your target-date fund is set up and to continue to monitor your investments, whether personal or through your employer, as this investment strategy is quite common through workplace retirement plans.

The pluses

Target-date funds are popular with 401(k) investors. Instead of having to choose several investments to create a portfolio that will help them reach their retirement goals, investors choose a single target-date fund to match their time horizon.

These funds mitigate the need for other assets. Some financial professionals advise that if you invest in a target-date fund, it should be the only investment in your plan. This one-and-done approach is recommended because additional investments could skew your overall portfolio allocation. After you’ve picked a fund, you have the ultimate set-it-and-forget-it investment.

The minuses

The autopilot nature of target-date funds can cut both ways. The predetermined shifting of the portfolio assets may not suit an individual’s changing goals and needs. People grow and change, and so do their needs. Target-date mutual funds are designed to meet an investor’s needs usually through retirement; however, there is no guarantee that the funds will generate the income needed.

It’s worth bearing in mind that similarly named target-date funds are not the same—or, more specifically, their assets are not the same. For example, all 2045 target-date funds will be heavily weighted toward equities, but some might opt for domestic stocks, while others look to international stocks. Some might go for investment-grade bonds, and others choose high-yield, lower-grade debt instruments.

Make sure the fund’s portfolio of assets fits your comfort level and appetite for risk. As with all investments, these funds are subject to risk and underperformance.

Furthermore, as investments go, target-date funds can be expensive. They are technically a fund of funds—a fund that invests in other mutual funds or ETFs—which means you have to pay the expense ratios of those underlying assets, as well as the fees of the target-date fund. Of course, an increasing number of funds are no-load, and overall, fee rates have been decreasing. Still, it is something to watch out for, especially if your fund invests in many passively managed vehicles.

Conclusion: Have a plan

If you decide to use a target-date fund, be sure to pick your target date carefully; select the date that aligns most closely with your retirement investment strategy. When comparing funds with similar target dates, examine their investment strategies so that you can select the one that best matches your tolerance for risk. Keep in mind that your circumstances could change along the way, so you should monitor the fund’s performance periodically to ensure it meets your investment goals.

When considering the best target-date funds, it’s important to note that different funds are designed with unique investment strategies in mind, and that can lead to different desired outcomes.

Traditional target-date funds typically follow set asset allocations or might be constructed to seek out performance of certain benchmarks (such as the S&P Target Date Indices, for example). These types of funds tend to be on the more conservative side and contribute to a balanced portfolio. On the other hand, goals-based target-date funds aim to achieve specific outcomes and may be more likely to be associated with growth and income generation.

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