Your Guide to Target Date Funds

What is a Target Date Fund?

Target Date Funds Defined

According to Investopedia a target-date fund is a mutual fund that is offered by a fund company (Vanguard, Fidelity, T. Rowe Price). Like the name implies, the fund has a target date for a particular financial event that will occur in the future. For example, the target date is the year a person plans to retire (the 2045 fund).

Investors use Target Date Funds to accumulate assets for their future use. For example, they accumulate assets that will produce future income during their retirement years. Most investors terminate their participation in Target Date Funds when they reach their target date.

Target Date Funds may also be the default investment in a 401k when plan participants have trouble selecting other investments.

Retirement is not the only Target Date. For example, the reason investors accumulate assets could be the funding a child’s education or the purchase of a second home (enhanced lifestyle). Also, assets that are being accumulated for retirement could be withdrawn from the TDFs when people change jobs.

What are the Pros and Cons for Target Date Funds?

Target Date Funds have pros and cons. Starting with the con’s: they are a simple investment. All investors have to do is select the target date and the fund does the rest. This simplicity appeals to a large percentage of unsophisticated 401k plan participants. 

Another pro is Target Date Funds automatically reduce investors exposure to risk as they approach their target dates. This feature appeals to a lot of investors, but it may also represent a hidden risk (see the con).

Pros Cons of TDF's glidepathwm.com

The con occurs when the target date fund does not reduce risk enough. For example, what if a fund was 50% invested in stocks and the market suffers a major decline the same year as the target date. This happened in 2000-2002 and again in 2008. Severe declines in the market value of investments could have impacted 50% of the investors’ assets the year they plan to retire.

Call it bad luck, but the severe decline near a retirement date could have catastrophic consequences. The decline may force people to defer retirement dates, reduce their standard of living, or take part-time jobs.

Not exactly the Golden Years people were expecting for their retirements.

The biggest con of a Target Date Fund is its one-size-fits-all investment strategy. Every person in a particular Target Date Fund is invested exactly the same even though there may be substantial differences in goals, circumstances, and requirements. For example, one investor may be very dependent on the assets in the target date fund. Another investor may be a lot less dependent. The first investor’s dependency may mean a much lower tolerance for risk. The second investor would have a higher tolerance for risk.

Another weakness is the rigid nature of the fund. Since everyone is invested the same, the fund cannot take into consideration the changing needs of investors that may occur over time.

For example, a person invests in a 2034 Target Date Fund and three years before retirement this person inherits a substantial amount of money. The inheritance changes everything, but the Target Date Fund keeps investing regardless of individual circumstances.

Another consideration is the target date itself. People invest based on anticipated retirement dates. On the other hand, many people will change jobs during their working years, so they are not retiring after working at the same company for 30 years. They may work for several companies during that time span.

How Popular are Target Date Funds?

It is estimated there was $2 trillion invested in Target Date Funds at the end of 2018. It is estimated this number will increase to $7 trillion by the end of 2025.

Do Target Date Funds Produce Market Rates of Return

A high percentage of Target Date Funds are invested in index mutual funds.

Index funds are designed to produce the performance of the market for particular asset classes. For example, the S&P 500 index fund replicates the performance of 500 large capitalization U.S. stocks.

A Target Date Fund will invest a percentage of its assets in this index, thereby capturing the performance of 500 large capitalization securities.

Good Target Date Funds

It is very difficult to differentiate between good and bad Target Date Funds because what is good for one investor might be bad for another. It takes research by the people investing in the funds to understand how the funds are invested, and which are likely to meet specific goals. 

The tradeoffs in all TDF asset allocations over time are between growth and safety. Some funds emphasize growth while others choose preservation of capital. This is especially true at the target date, where there is a wide dispersion of asset allocations across TDFs. Some believe that a good allocation at the target date is aggressive because people don’t save enough while others say safety is paramount because account balances are at their highest amounts.

Beyond standard TDFs, there is a form of TDF that qualifies as the “Best.” It’s described in the section below entitled “The Best TDF.”

Target Date Fund Glide Paths

Most Target Date Funds use glide paths that control the allocation of assets in the funds.

For example, when people are in their 30’s and their target dates are 30 years away their glide paths will allocate most of their assets to the stock market. They will also have minimal exposure to bonds and cash equivalents (CDs, money market funds) that are safer investments.

The theory behind this allocation strategy is stocks always outperform bonds and bonds always outperform cash equivalents over longer time periods. These relationships have to be true or no rational investor would invest in stocks.

The glide path also assumes younger people have more years to recover from bad performance years, therefore they can afford to take more risk.

As people age and get closer to their target dates, their glide paths automatically reduce their allocations to higher risk investments (stocks) because they have less time to recover from bad years.

Target Date Fund Fees

A high percentage of Target Date Funds are fund of funds, that is they are mutual funds that invest in other mutual funds. In general, investors in these funds are paying two layers of fees or more.  

People should conduct their own due diligence before they invest their assets in TDFs. 

People should demand full written disclosure for all fees that will be deducted from their accounts. How much is deducted, who gets the money, and what services do they receive for their money.

Largest Target Date Funds

According to Pension & Investments the largest TDF providers in Defined Contribution Plans as of June 30, 2018 were:

  • Vanguard Group ($212 Billion)
  • Fidelity Investments ($179 Billion)
  • T. Rowe Price Group ($121 Billion)
  • Capital Group ($87 Billion)
  • J.P. Morgan Asset Management ($54 billion)
  • Nuveen ($37 Billion)
  • BlackRock ($21 Billion)
  • John Hancock Funds ($16 Billion)
  • American Century ($15 Billion)
  • Voya Investment Management ($7 Billion)

401k Target Date Funds

Most TDFs are investment options in 401k plans. That’s because assets in 401k plans all have potential target dates – the years the plan participants plan to retire.

Some plan participants may be retiring in the next five to ten years, while other participants may have 30 or more years before they retire.

Why Do TDFs Matter?

Millions of Americans have entrusted their retirement savings to Target Date Funds and the glide paths that drive their asset allocation processes.

TDFs make investing simple. All people have to do is select the target date (a year in the future) and the funds do the rest.

Funds automatically reduce risk as they get closer to the target date. There is always the risk that the securities markets will experience a severe down-turn during the target date year. If the decline is severe enough it could force people to change their plans – for example, defer their retirement until their assets recover their value.

How to use a TDF?

Target Date Funds (TDFs) make their selection simple. To select a TDF, all people have to do is select their target dates, for example the year they plan to retire – let’s say that year happens to be 2040.

The fund does the rest in regard to asset allocation, security selection, and buy/sell decisions. 

The glide path for the TDF manages the allocation between stocks, bonds, and other asset classes.

The Best TDFs

Because of the one-size-fits-all problem, which is very serious, the best target date funds are not actually funds — they’re portfolios. Individual investors can design their own Target Date Portfolios that meet their unique needs. Importantly, Target Date Portfolios (TDPs) can be adjusted through time as life events change investor circumstances.

Investors can manage TDPs on their own, but most should get the help of a professional advisor. There are important lessons in TDFs that advisors can guide you through as you navigate through a lifetime of investment decisions.

The Complete Guide to TDFs

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The Employee Benefits Security Administration of the U.S. Department of Labor provides a comprehensive guide to investing in TDFs for retirement: https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/target-date-retirement-funds.pdf.

The more people know about TDFs the higher the probability they will make the right choices when they invest in them for retirement.

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