Target date funds (aka life cycle funds) have become relatively popular in recent years. They have been around since the 1990s, but became more ubiquitous with the passage of the Pension Protection Act of 2006. This law generally allows such funds to be chosen as the default investment in a 401k plan if the participant does not select other investments.
Investors can also invest in a target date fund in other ways as well. Examples include purchasing directly from a fund company, via a broker in a taxable brokerage account, or inside another tax deferred pension plan such as an IRA. Vanguard, Fidelity, and T. Rowe Price are among the largest managers of target date funds.
Target date funds are usually mutual funds, but can also be ETFs. See Mutual Funds vs ETFs – Which is Best for You? for a comparison between the two types of investments.
General Overview of How Target Date Funds Work
Target date funds provide investors with an even more passive way to invest than just using regular index funds. Target date funds can be used to invest for any long term goal, but are typically geared towards investing for retirement. Investors generally choose a fund with a date closest to when they expect to retire (target date). Target dates are usually available in five year increments.
Professional fund managers then manage the target date fund portfolio according to this time horizon. It should also be noted that the target date is not a specific day. Instead, it is a year. It represents the approximate time the fund holder expects to retire.
As the time to the target date approaches (and often thereafter), the asset allocation typically shifts less to equities and more to fixed income and cash equivalents.
One Fund Diversification With Automatic Asset Allocation and Rebalancing
Target date funds can invest in stocks, bonds, and other securities. Typically, however, they mostly invest in other mutual funds. As such, they are usually “funds of funds.” They are designed to eliminate the need for the investor (or an advisor) to have to select several different mutual funds or other securities in constructing a suitable portfolio.
Target date funds also automatically adjust their target asset allocation mix as the target date approaches to make it more conservative. The change in this asset mix over the fund’s lifetime is called its “glide path.”
Equities are deemed more volatile and risky, but also have higher average historical returns. As such, they are overweighted early on in order to grow the portfolio. As the target date approaches, preservation is more of a concern, and the allocation incorporates more bonds and cash.
Finally, the fund managers also automatically rebalance the portfolio periodically as necessary in order to maintain the asset mix according to the specific fund’s stated glide path.
It is important to realize, however, that funds with the same target date can be very different. They can have different glide paths, as well as starting and ending asset mixes.
Target Date Funds Do Not Necessarily Replace The Need For a Financial Advisor
Granted, especially if you do not use the services of an investment advisor, a target date fund can allow you to benefit from professional asset allocation and rebalancing. It may even be less expensive.
However, you should also understand that a financial advisor can provide services besides just asset allocation and rebalancing. Advisors can help with insurance needs, budgeting and cash flow analysis, tax and estate planning, etc.
Target Date Funds Help Eliminate Emotional Investing
Do it yourself investors often make some very common mistakes. For starters, they may take on too much risk, or not enough. They may also chase a hot market at its top, only to sell after it crashes. They then miss out on the eventual recovery. This results in buying high and selling low. This is the exact opposite of what you ideally want to do.
Emotional attachment to certain stocks or funds can also present issues. For example, you may not wish to sell a particular investment due to its outperformance, because it’s in your favorite industry sector, etc. This can prevent you from making necessary adjustments to asset mix or for rebalancing purposes.
“To” Versus “Through”
Most target date funds begin with a stock allocation of about 90% when the target date is several decades away. But where that allocation ends up by the target date, and how it gets there, usually differs among funds.
“To” target date funds have a glide path which flattens out once it gets to the target date. This means that the asset allocation mix reaches its most conservative point, and remains fixed thereafter. These funds usually reach the target date with a lower allocation to stocks (equities). Usually around 20 to 30%.
“Through” funds, on the other hand, have a glide path which continues to make the asset mix more conservative for several years after the target date is reached. These funds typically have a higher allocation to stocks at the target date, usually around 50 to 55%.
What Happens Once The Target Date Is Reached?
With regard to reaching the target date, it is important to clear up a common misconception. Target date funds do not guarantee you will have enough to retire once you reach the target date. A lot of that depends on how much you invest over the years and how early you start.
It is also important to realize that the allocation does not shift to 100% cash and cash equivalents at the target date. The funds are not liquidated at the target date either. Target date is when you plan to BEGIN using the assets. As such, the fund assets continue to be invested in a way that will still generate some income and hopefully a total return above inflation.
These funds typically continue operating with a more conservative asset allocation for several years after the target date. Then they usually ultimately merge into another fund with a similar steady, income producing, asset mix.
Some “to” date funds can merge into other funds as soon as a couple of years after the target date is reached. Others though, especially “through” funds, can continue to adjust their asset mix 10, 20, and even 30 years after the target date.
Asset Allocation At Target Date May Not Be Suitable
Another misconception which must be addressed is that target date funds do not carry any risk once they reach their target date. Fixed income investments such as bonds are generally deemed more conservative because they are less volatile on average than equities (stocks).
But such investments can still be risky. A rise in interest rates, for example, can cause the value of bonds to drop. Especially if they have longer maturities. Further, when you have a long time horizon, “conservative” investments such as bonds and cash may actually be even riskier. Inflation can be a big threat to the purchasing power of funds over long periods of time, such as during retirement for many people.
This is why these target date funds typically have a significant stock allocation at (and during) retirement. But for many investors, this allocation may be too conservative and insufficient in many of these funds. The last thing anyone wants is to have to try and figure out how they’ll make ends meet when they’re 85.
As discussed in How Much Do You Need To Retire?, life expectancies are on the rise, and many investors need a higher allocation to stocks in order to fight inflation and increase the longevity of their portfolios. If you want a higher stock allocation once you reach retirement, you can invest in a fund with a later target date and an appropriate glide path and asset mix. And vice versa if you want the opposite.
Another alternative is to just sell all or part of your position in the target date fund. Then you can invest directly in other funds or otherwise direct the proceeds to meet your objectives.
Less Flexibility and Control
In exchange for the automated asset allocation and rebalancing, you do give up some control. For many investors, this is just as well. As discussed above, emotions combined with more control can often result in more harm than good.
But if you want to be more hands on, target date funds may not be ideal for you. Maybe you feel you have the capability and knowledge to make tactical moves to improve returns. Or you wish to do so with the help of your advisor.
Target date funds may not rebalance with the frequency you prefer. Or they may not shift their strategic asset allocation mix in line with your preferences. Maybe you want to take advantage of a perceived opportunity by overweighting or underweighting a certain asset class, industry sector, etc.
Of course, if you have extra funds, you can invest in other opportunities outside of the fund. You may even be able to make other investments to change the asset mix.
Also, as the size of your portfolio grows, you may wish to have greater flexibility. Maybe you are way ahead of what you’ll need for retirement and want to allocate a portion of your portfolio differently for a separate goal. In such a case, you can sell off part of your fund and invest the proceeds elsewhere.
If you have a sufficient size portfolio, it may also be less costly to invest directly in stocks, bonds, ETFs, and non-target date mutual funds.
Investments in Addition to a Target Date Fund May Change your Overall Asset Allocation Mix
Investing in one target date fund for a particular goal such as retirement is ideal for purposes of monitoring your overall asset allocation. However, if you have different investments in a 401K, IRA, and a taxable brokerage account, for example, you must keep track of your overall asset mix.
There can be overlap, insufficient investment in certain asset classes, etc. If you do have savings in various different accounts for one particular goal, one solution may be to invest in the same target date fund in each account. This way you can maintain the same overall asset mix.
So at the very least, make sure you understand your overall weighting to the major asset classes. You may have to do some rebalancing if you have different funds and other investments.
Active vs Passive
Like other funds, target date funds can be passive or more actively managed. Passive target date funds generally invest in index funds and try to match the performance of their benchmark. This may be an S&P or Dow Jones target date index, for example.
Active target date funds generally invest in actively managed mutual funds. Their objective may be to exceed the returns of their benchmark, or to meet a specific goal. For example, goals based funds may look to maintain a specific level of volatility or to generate a certain minimum amount of income.
Fund Expenses and Fees
Target date fund investors can be subject to two layers of fees. The first is the expenses of the underlying mutual fund investments. These are costs you would likely pay even if you purchased the funds directly.
The second would be the management fee and other expenses of the target date fund itself. This is the price you pay for the efficient diversification and automatic allocation and rebalancing. Inside a 401k plan, this fee may be worth it. And some fund companies do have very reasonable fees. But if you have an advisor managing an IRA or taxable brokerage account, there may be some overlap in the fees that you pay.
Regardless, passive target date funds typically have lower expense ratios than their active counterparts. However, expenses do differ among all types of funds. So it pays to do your homework and shop around.
Target Date Funds Used For College Savings Plans
Target date funds are also used in section 529 college savings plans. But instead of the target date being retirement, it’s the year the student is expected to enroll and begin paying for college.
Target date funds used for this purpose are usually out of stocks completely by the time the target date is reached. The college time horizon is much shorter than retirement. So inflation is less of an issue post target date.
Always look at the prospectus to find out more about a particular investment fund before you invest. Here you can find information on the fund’s fees and expenses, underlying investments, and glide path. Although target date funds are designed to be hands off investments, you can’t forget about them completely. Be sure to check back periodically for any potential changes after your initial investment.
Costs can vary widely for different funds. Some may have significantly higher expense ratios than others. Even a small difference can make a big impact in the long term. FINRA’s Fund Analyzer tool can also be very useful in researching fund costs. Also, for mutual fund target date funds, make sure to invest in the share class appropriate for your situation.
Finally, you may be enrolled in a target date fund automatically via your employer’s 401K plan. So make sure to check your 401k statements to avoid any future surprises.