What to know about Target-Date Funds in Corporate Retirement Plans
What they are?
Target-date funds also referred to as life-cycle funds or age-based funds have become very popular in corporate retirement plans. Essentially, what you do is pick a fund, put as much as you can (and allowed) into the fund, then forget about it until you reach your retirement age. If you have a 401(k) plan, a target-date fund may be an easy way to get into a portfolio that will automatically rebalance based on your time until retirement.1
By far the three largest firms in the target-date funds market are Vanguard, Fidelity, and T. Rowe Price.2 These companies have a combined market share of over 70% of target-date assets in 2015. For younger professionals entering the workforce, the appropriate target-date fund option in their employer’s 401(k) plan can be a great option. In most cases, these newer members of the workforce have few, if any, investments outside of the 401(k) plan, and target-date funds can offer a professionally managed and diversified portfolio.
The investments in these three target-date funds are all made up of underlying funds from their respective fund families. In the case of T. Rowe Price and Vanguard, these are the same funds' investors can buy individually. When offered in a 401(k) plan the vast majority of employers, according to Fidelity, use target-date funds, and 90% of which have it as the default option in the plan. You should also know more about how target-date funds work and if they are right for your retirement goals.
How do they work?
For target-date funds, the idea is that as you get older, the most important thing to understand is your fund’s “glide path.”3 This refers to how the fund’s asset allocation — a mix of stocks, bonds, and cash changes over time as you get closer to the “target date” year in the fund’s name. As you near retirement, your fund “glides” from being growth-oriented (mostly stocks) to be more conservative (mostly bonds).
For example, someone in their 20s and 30s will be more heavily invested in stocks, which can come with more risk, and the target-date fund portfolio will automatically adjust (or rebalance) to be more heavily allocated into bonds and conservative investments as that person gets near retirement. The target-date fund assumes you will be at full retirement age in that year.
A target-date fund operates under an asset allocation formula that assumes you will retire in a certain year and adjusts its asset allocation model as it gets closer to that year. The target year is identified in the name of the fund. So, for instance, if you plan to retire in or near 2050, you would pick a fund with 2050 in its name.
The “normal retirement” path is that as you get older, the ratio of stocks to bonds in your retirement portfolio should change. At the beginning of your career, you can take on more risk because you most likely won’t need the money for several decades. For that reason, a higher percentage of higher-risk stocks is allocated in your target-date fund. As you get closer to retirement, you have to better protect your assets, so you should have a higher percentage of bonds. A target-date fund makes all those weighting adjustments for you.
One common misconception is that you have to pick a target-date fund with a date of your projected retirement. You can pick any fund, with funds further away from the target date, the greater the risk since there are more stocks than bonds in the fund; but there could be a potential for greater return.
Are they any good?
To see if target-date funds are good choices we must consider costs. The cost of a mutual fund is known as its expense ratio, an annual fee expressed as a percentage of your investment. Target-date funds come at a price. You have to pay more to have a fund that automatically adjusts on your behalf. The average target-date fund has an expense ratio of 0.51%. That means that your $10,000 investment will cost you $51.00 per year just for the service the target-date fund offers. However, if you buy separate funds that make up the target-date fund your expenses can be considerably less.
The biggest issue with target-date funds is active versus passive management. Research shows that when compared with indexing, active portfolio management has some major drawbacks.4 Active managers typically underperform their benchmark indexes. Thus their returns are usually less than those of the indexes. Active management adds expenses that are charged to investors, further reducing returns.
The academic research says that the most reliable predictor of the performance of two similar funds is operating expenses, the net expense ratio. If you do choose a target-date fund, keep in mind that they may be more expensive than other options since it has a one-size-fits-all strategy. Vanguard’s expenses are low due to their use of passive low-cost index funds. Fidelity and T. Rowe both primarily use actively managed funds, which carry higher costs. These expenses add up over time and can have a significant impact on your portfolio over time.
What are my options?
For those approaching retirement, it may be better to diversify into other investments rather than just use a target-date fund. These would include investments outside of your 401(k) plan, such as taxable brokerage accounts, and IRAs.5
These increasingly popular target-date funds, however, may not be best for all investors since they limit your choices and investment decisions within your account. But, target-date funds are a great option for 401(k) plans for novice and beginner investors.
I believe the best option, if available, is a lower-cost index option for your target-date fund. When getting closer to your retirement, it might be wise to talk to a financial planner to customize a portfolio that better meets your needs. This can be as easy as picking 4-6 different funds that make up the underlying target-date funds and reduce the higher expenses that you pay with target-date funds.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.