It would certainly be nice if saving for retirement were as simple as setting a date, pointing your investment account in the right direction, and walking away for a few decades, returning to find everything ready when you needed it.
Target-date funds have rapidly gained popularity because they promise to take investors to retirement and beyond, while removing the hassles of dealing with asset allocation, portfolio rebalancing and interest rate risk. But can they really make things that simple?
Yes, but only to a point. While target-date funds have their uses, investors need to stay active in planning for their retirement. One-size-fits-all will never fit any one person quite as well as something tailored, whether it’s a three-piece-suit or a retirement plan.
You can think of a target-date fund as a wrapper that holds investments in several underlying mutual funds or exchange-traded funds (ETFs) within a single security. The fund is tied to a date in the future, usually presumed to be the fund holder’s projected year of retirement. At regular intervals, the fund is automatically adjusted between different holdings to reflect market behavior and to reduce exposure to riskier assets (usually stocks) as the retirement date approaches. This change in allocation is called the fund’s “glide path” and is designed to reduce the potential harm of a big market downswing close to an investor’s retirement date that leaves too little time to recover.
There are several reasons target-date funds have become popular so quickly. First, target-date funds are convenient, because they allow investors to gain access to several asset classes within a single fund. A level of diversification is built in. These funds can take some of the stress out of having to actively manage a portfolio, which can make them attractive investments for those who do not have the time or the inclination to manage their own portfolio but who lack the resources to hire an investment adviser directly.
Another contributing factor to the funds’ popularity is the safe harbor rules created under the 2006 Pension Protection Act, which made target-date funds a qualified default investment for 401(k) plans with automatic enrollment. (See chart below for data on the growth of target-date fund assets). Many companies now use the funds as the default choice for their employees, who often find inertia simpler than making an active decision about their investments.
| Target-Date Fund Assets by Account Type (in billions, at year-end) | |||
|---|---|---|---|
| 2002 | 2006 | 2012 | |
| Defined Contribution Plans - 401(k), 403(b), 457 plans, etc. | $11 | $83 | $344 |
| IRAs | $2 | $25 | $93 |
| Other Accounts | $1 | $7 | $43 |
| Total Assets | $15 | $115 | $481 |
| Source: Investment Company Institute 2013 Factbook, 53rd Edition, (http://www.icifactbook.org/) Amounts may not sum due to rounding. | |||
Target-date funds are not a panacea, however. Many of these funds come with features that should make investors wary. One is cost. The overall expense ratio may simply be a weighted average of the management fees of the underlying funds, or the fund operator may charge an additional fee on top of the underlying funds. A major factor in the overall cost is whether the target-date fund uses index or actively managed funds. Index funds tend to charge lower costs than actively managed funds because they just track a benchmark and require less oversight. Managers of actively managed funds strive to beat their respective benchmarks by adjusting the fund’s portfolio based on their interpretation of market conditions. Because of more manager oversight, these funds tend to have higher management and administrative costs. As with other 401(k) or investment account fees, investors should be sure they know what they are paying for.
Some investors also perceive target-date funds as inherently safe investments, or worse, as guarantees of having enough for retirement. In reality, different target-date funds offer very different levels of risk. Further, many target-date funds take as a given that bonds are safer than equities, and so will weight bonds more heavily as the investor approaches the fund’s target date. Given the current low interest rate environment, the margin of safety offered by bonds over equities is not so clear-cut. Future rises in interest rates will mean lower bond prices. The impact of the changing rates will depend on the duration of the bonds in the fund. In general, bonds with a longer time to maturity will see greater price declines as rates rise.
How much damage investors will suffer as a result of rising rates will depend on how quickly and how high rates rise, as well as the composition of the particular fund’s bond investments. Funds with higher allocations to long-term bonds will see larger losses than funds that have shorter-term bond holdings. Those who happened to retire during 2008 or 2009 faced a stock portfolio battered by the recession; retirees who invest in target-date funds that take the safety of bonds as a given may soon find themselves in a similar situation.
Besides understanding the general risks of target-date funds, investors should be aware that not all target-date funds are the same, even if they have the same target year. Each fund family has its own philosophy regarding which asset classes (for example, commodities or real estate) should be included in its target-date fund lineup, how frequently the fund will rebalance, and when and how quickly the fund will shift to investments that are more conservative. If investors do not understand their fund family’s strategy, they could easily find themselves invested in a fund that is not appropriate for their situation. Below is a chart that compares the asset allocations as of June 30, 2013, for funds from three of the largest target-date fund issuers with the same target date.
| Asset Class | Vanguard TargetRetirement 2015 (VTXVX) | Fidelity Freedom 2015 (FFVFX) | T. Rowe Price Retirement 2015 (TRRGX) |
|---|---|---|---|
| Cash | < 1% | 6% | 2% |
| Domestic Bonds | 37% | 41% | 29% |
| International Bonds | 9% | 3% | 9% |
| Domestic Equities | 38% | 32% | 42% |
| International Equities | 16% | 14% | 19% |
| Other* | - | 5% | < 1% |
| *The Other Category is comprised of Commodities for the Fidelity Fund and Preferred Stock and Convertibles for the T. Rowe Price Fund Amounts may not sum to 100% due to rounding | |||
As you can see, the composition of the funds can vary widely. What these numbers do not show is the differences within the various asset classes. For example, the Fidelity Freedom Fund comprises more than 25 actively managed mutual funds, while the Vanguard Fund allocates its assets to 5 broadly diversified index funds. This further illustrates the need to understand the composition of a given target-date fund before investing.
Investors should also understand that the proper fund for them might not be the one targeted for the year they expect to retire. For example, individuals with a higher risk tolerance might prefer to maintain a higher weighting to stocks through retirement. They should consider investing in target-date funds with a date later than their expected retirement year (such as 2030 instead of 2020). Target-date funds typically have higher exposure to stocks the further they are from their target year, so choosing a date farther in the future tends to preserve a higher level of stocks and potentially higher returns. It is also important to realize that some funds aim to reach their most conservative level at their target dates, while other funds may not shift to their most conservative allocation until years later. This all depends on the philosophy of the fund operator. It is essential to ensure the selected fund matches the investor’s goals.
Selecting a target-date fund should involve the same sort of due diligence involved in selecting any other investment. It may be helpful to examine a company’s target-date fund for current retirees to obtain some idea of what a portfolio close to retirement might look like. This exercise is most useful for someone looking to invest in a target-date fund with a date closer to the present. The further away the target date is, the more likely it is that the fund operator could change the fund’s strategy before the date is reached.
Beyond the questions discussed above, investors should also consider:
- How the allocation of the target-date fund fits with the other investments in their portfolio
- Their risk tolerance, both in the present and in the future
- Whether the fund uses actively managed investments or index funds
- How much tactical freedom the fund manager has to depart from the glide path if market conditions change
- How often the fund rebalances
All of this is not to say target-date funds are never useful. Many investors have useful allocations to target-date funds. There are many logical reasons for this. Gone are the days of defined benefit plans, and investors must now save for their own retirement. Investors often have little else in their portfolio outside their retirement account(s), many of which are likely to contain target-date funds by default. Also, many investors do not feel comfortable managing their own portfolios. Target-date funds guarantee a certain default level of professional expertise, which some investors find comforting.
However, investors in target-date funds shouldn’t think they can simply “set it and forget it.” Few investors would give money to an investment adviser and then neglect to check in for 10, 20 or 30 years. Why do the same with a target-date fund? Investors should review their fund’s asset allocation and expenses regularly. In addition, while an investor may have selected a fund that was right for his or her needs at the time, those needs can subsequently change. Inflation, rising interest rates, a new job, a changed family situation or new plans for retirement can all factor into making a formerly good fit an uncomfortable one. Even if the investor’s personal situation has not changed, the fund family’s philosophy may have.
When deciding to invest in a target-date fund, investors need to know more than just the year that they plan to retire. And, as with any other investment, investors should monitor their fund’s objectives and investment strategy over time, to let them make adjustments when necessary. Those who don’t may find that their target-date fund ultimately missed its mark.
