The Good, Bad and Indifferent With Target Date Funds

Mon, Nov 12, 2018 - 11:22am

The person that developed Target Date Funds (TDF) is a marketing guru. The premise is to develop a fund an investor can stay in over their lifetime that will automatically reduce risk over time as the person approaches retirement. The concept is simple in nature and has spread like wildfire as the investment of choice for most individuals who use 401k’s. In fact, per Fidelity as of the first quarter of this year, 52 percent of individuals have their entire 401k invested in target date funds and for millennials that number was 70 percent.

Let’s take a quick look at how they work. The target date funds are what are called a fund of funds. This is where one mutual fund is a basket of several other mutual funds. A target date fund typically will have five-10 other mutual funds inside it. The target date fund then simply follows a glidepath that gradually reduces exposure to stocks over time.

For many people, especially those that want to be hands off the target date fund makes sense given its simplicity. It is truly a set it and forget it approach to retirement investing that can remove emotions from the investment decision process. The fund will automatically adjust over time and will maintain a diversified portfolio.

Unfortunately, they are not right for everyone and it is important to understand how they work to help you determine if they are the best option for you. They are not ideal for individual seeking active management or for people that like to be involved in the investment decision process. Another challenge is they assume one size fits all and do not account for an individual’s risk tolerance. The portfolios by nature may be more aggressive than an investor is comfortable with. For example, a target date fund for someone trying to retire in 2030 would be in a portfolio of about 65% stocks. In a crisis it would not be unrealistic for this allocation to lose 30% or more. I know several clients that are not comfortable with that type of potential loss. It is important to understand your risk tolerance and the risks of the target date fund to help ensure they are aligned.

Not all target date funds are created equal. Funds vary greatly in allocation, glide paths and fees. Some funds are managed to retirement and some through retirement. Depending on the glide path some target date funds do not change once you reach the retirement age while others will continue to become more conservative through retirement.

Since they are a fund of funds, target date funds tend to carry higher fees than other alternatives. Looking at a sampling of the most common funds, I found fees ranging from 0.14 percent (Vanguard) to 0.7 percent (Fidelity) for common target date 2030 funds. Looking at fees for those in retirement, the fees ranged from 0.13 percent (Vanguard) to 0.57 percent (Fidelity). Please keep in mind these are for institutional shares-- the shares you can choose may have higher fees.

As with any investment decision before committing, do your homework and make sure you understand the investment and that it matches your risk tolerance and look under the hood to understand the funds characteristics like asset allocation, glidepath and fees. Target date funds are a great investment strategy for many investors, but they are not a magic bullet and are not suitable for everyone.

About the Author

Paul Horn CFP