Not sure how to invest your 401(k) plan savings? Target date retirement funds have become a popular option for making that decision a little easier.
Investments in a target date fund are structured according to when you plan to retire. Then those investments are gradually adjusted as your retirement date approaches. If you're looking for a retirement savings plan that lets you set it and forget it, a target date fund could be a reasonable option.
It's certainly a popular approach. According to Morningstar, $1.9 trillion was invested in target date funds as of the end of March, 2020.
But are these funds right for you?
A good way to know is to explore the advantages, issues and alternatives to investing in target date funds. Here's what you can learn from this article:
- What target date retirement funds are
- How target date funds help with asset allocation
- Limitations of target date funds
- Examples of target date funds
- How to invest in target date funds
What Are Target Date Retirement Funds?
Target date retirement funds are mutual funds designed to match investments with the timing of when you plan to retire.
They are typically offered as part of a family of target date funds with a series of different dates. For example, on a 401(k) plan menu, you might see:
- 2030 target date fund
- 2040 target date fund
- 2050 target date fund
- 2060 target date fund
The idea is that you pick the fund with the target date closest to when you plan to retire. You would then get a mix of investments chosen to suit the typical needs of someone with that fund's target retirement date.
What Makes Target Date Funds Work?
The key to how target date funds work is asset allocation.
Investments are divided into broad categories known as asset classes. Examples of different asset classes include stocks, bonds and cash.
Each asset class has different investment characteristics, for example:
- Stocks are designed for long-term growth but may experience wide swings up and down in value in the near term.
- Bonds are designed to produce regular income but have limited growth potential.
- Cash provides immediate liquidity but produces relatively little investment return.
Investors generally use a mix of different asset classes to adjust the level of risk they are taking.
Generally speaking, younger investors have a longer time to ride out the ups and downs of the stock market, so they can afford a higher allocation to stocks.
In contrast, older investors are generally more interested in stability and income production, so they tend to own fewer stocks in favor of more conservative investments.
Thus, asset allocation is a basic tool for matching the risk/reward potential of your investments with your needs. Target date funds are designed to make this important asset allocation decision for you.
The glide path
A key concept in how target date funds help you invest for retirement is known as the "glide path."
The glide path is the gradual adjustment of your asset allocation as you get closer to retirement.
This means that not only will a target date fund give you an asset allocation geared toward your time horizon when you first invest in it, but it will steadily shift that allocation to more conservative investments as your retirement date approaches.
The glide path is what gives target date funds the appearance of "set it and forget it." That's because the fund is managed to make changes for you as time goes by.
Limitations of Target Date Funds
Target date funds are designed to meet the general needs of investors of roughly the same age. This means they may work fairly well in most situations but won't always be the best solution in some specific cases.
A hands-off approach to investing may offer advantages, but the limitations of the target-date approach to investing are significant. Here are five issues to evaluate for your retirement savings plan:
Retirement plans vs. reality
The target retirement date you choose when you are 30 years old may be very different from when you actually retire. As your career goes on, you'll need to occasionally consider whether your retirement plans have changed enough to prompt a change in your target date fund.
Asset allocation approaches differ
Target date fund managers have differing opinions of what is the correct asset allocation at any given age. This is particularly true of how they handle the mix of asset classes once the target date is reached.
While the general approach is to shift to a very conservative asset mix by the target date, this might not always be appropriate for someone who goes on to live 20 or 30 years in retirement.
Not everyone's risk tolerance is the same
Not only might your financial situation differ from that of someone else your age, but your attitude toward risk might be different too. Target date funds are not designed to take into account personal preferences for more or less investment risk.
Market conditions change
If you are looking for a fund manager that will back off from stocks when the market is riskiest and invest more aggressively when opportunities seem ripe, most target date funds are not designed to do that. They are generally designed around the assumption that long-term market conditions will repeat themselves in the future.
Value of retirement savings may differ
How much you have saved for retirement relative to your spending needs can make a difference in how aggressively you should be invested. Target date funds do not account for this in any way.
Largest Target Date Retirement Fund Managers
Dozens of mutual fund companies offer target date funds, though the market is dominated by a handful of the largest fund managers. Based on Morningstar's data, as of March 31, 2020, the five largest managed roughly 80% of all target date assets.
Those five largest target date fund families were:
- Vanguard target date funds: $722 billion
- Fidelity target date funds: $262 billion
- T. Rowe Price target date funds: $226 billion
- BlackRock target date funds: $172 billion
- American Funds target date funds: $137 billion
However, the largest funds aren't necessarily the best for your needs. There are factors other than size you should look at when choosing a target date fund.
Finding the Best Target Date Funds: What to Look For
When you are trying to choose a target date fund, here are some of the factors you should consider:
- Glide path approach
This includes both how the fund approaches asset allocation now and how it adjusts asset allocation once the target date is reached.
Some funds use an asset allocation model based solely on the time frame while others also take into account market conditions.
In addition, some funds keep a constant allocation once the target date is reached, while others continue to make adjustments to reflect how needs may change through a person's retirement years.
- Track record in up and down markets
The popularity of target date funds has led many newcomers to join the scene in recent years, but it helps if a fund has been around long enough so you can evaluate performance both in the severe bear market from the start of 2008 through early 2009 and the subsequent bull market that followed.
For more conservative funds (those with a closer target date), your focus should be on how well the fund held up in the bear market.
For more aggressive funds (those with more distant target dates), your focus should be on how they performed over the full period, including the bear and bull market phases.
- Experience and continuity of management
A fund's track record is only relevant if the management team has been in place for a long time. Check out each fund's management team to see how long it's been in place, how experienced it is and how deep it is (i.e., whether it relies too much on a single person or if there's a team that shares responsibility).
- Expense ratio
This measures the management fee plus operational cost of the fund. The cheapest isn't necessarily the best, but cost should always be considered when choosing investments.
Alternatives to Target Date Funds
Target date funds take a generalized approach to asset allocation based on when you plan to retire. Alternative approaches include:
- Choosing your own asset allocation. You can do this in a typical online brokerage account by choosing a mix of individual investments or mutual funds to fit your needs.
- Investing in a multi-asset class fund. Some mutual funds use a blend of different asset classes based on things other than a target retirement date. This might be determined according to a permanently set asset mix or adjusted according to markt conditions.
- Using a robo-advisor. These are automated tools designed to assess your needs and risk tolerance and set an asset allocation accordingly.
Investing in Target Date Funds
If you participate in a 401(k) plan, it's likely that the investment menu for that plan has a series of target date funds on it. This makes it easy to choose the fund that best matches up with your retirement plans.
If you don't participate in a 401(k) plan, or if you have additional assets you want to invest, you can still use target date funds. You can buy them directly from a mutual fund company or through an online broker.
Target date funds may not meet the needs of all investors. For those who aren't sure how to invest their retirement savings, though, they can give you a quick head start to matching your investments with your retirement plans.