How Do Target Date Funds Work
Target date funds offer the simplicity of investing in one product and having the asset allocation change over time as you age.
This allows for a transition from more stocks to more fixed-income and cash-equivalent investments to match your recommended risk levels by age.
This transition, referred to as the glide path, can help investors who do not pay close attention to their retirement holdings across time.
An investor need only select the fund best-matched to their intended retirement date and hold the investment.
This results in better tax consequences and eases concern by not needing to worry about rebalancing, asset selection, or any other investing due diligence.
How Target Date Retirement Funds Work
Target date retirement funds feature a date in their name. For example, the funds weve discussed are 2050 funds. The date corresponds to the investors planned retirement date. Somebody seeking to retire in about 30 years would be especially interested in 2050 funds.
Target date retirement fund offerings are typically spaced out in 5-year increments, meaning there are 2045 and 2055 versions of the funds weve explored. Picking a retirement date is not an exact science and things do change. Still, having a target date in the fund name provides some useful information about the funds asset allocation today and in the future.
Target date retirement funds hold a combination of U.S. stocks, international stocks, and bonds. The specific weighting of those asset classes adjusts over time and can vary between mutual fund companies. The expense ratio associated with target date funds goes, in part, toward paying for these adjustments. Allocation adjustments are made based on glide paths, which are predetermined rebalancing plans that each target date retirement fund follows.
As investors get closer to their chosen retirement date, target date funds shift more heavily toward bonds and away from stocks. This shift is meant to reduce portfolio volatility during investors retirements. An attractive approach in theory but one that can create some pitfalls, which well address next.
Look For Retirement Funds With Low Fees
One thing that investors frequently overlook is the cost of holding a mutual fund, which is called an expense ratio. The company offering the fund imposes this fee on an annual basis as a percentage of your investment to help cover its operational expenses. The best retirement funds have lower expense ratios. They allow you to keep more of the returns on your investment, which results in a higher portfolio value at the time of retirement. In contrast, the higher fees of expensive funds can eat into your returns over time, resulting in a smaller nest egg.
For example, lets say that youre considering investing $100,000 in a mutual fund that has an expense ratio of 1% a year versus one that only charges 0.50% per year. The second fund saves you $500 a year in feesmoney that can continue to grow in your retirement portfolio. The longer your time horizon until retirement, the more that extra $500 a year adds up.
A 2018 fee study by Morningstar put the average expense ratio for mutual funds and exchange-traded funds at 0.48%, but ratios can vary depending on the level of management required for the fund. Actively-managed funds had an average expense ratio of 0.67%, while passively managed funds that track major indexes cost only 0.15% per year.
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Fidelity Target Date Funds
Other companies offer options as well. Fidelity offers Fidelity Freedom Funds, which run higher in terms of expense ratios.
From a brief review at the time of this writing, I saw Fidelitys Freedom Funds run between 0.46%-0.75%.
Despite the higher cost, these investments can still offer better suitable choices for those not interested in manually maintaining their portfolio.
Fidelity also offers its Fidelity Freedom Index Funds which come at a fraction of the cost.
These all maintain expense ratios of 0.08%-0.12% , much lower than the actively-managed Freedom Funds.
These entirely-passive funds afford the lower expenses by having less intervention from active managers when making asset allocation decisions.
Save The Date: Target
Planning to retire in 2040? Theres a fund for that. Looking to retire in 2055? There is a fund for that, too.
When investing in your 401 or other retirement savings account, target-date funds, also known as life-cycle funds, are one popular option. You pick a fund that is dated around when you plan to retire, and that fund promises to rebalancethat is, shift the risk profile of its investmentsas you approach that date.
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Target Date Funds Make Retirement Planning Easy
Everyone can invest their retirement savings in a target date fund. Its just a matter of where you choose to do your investing.
If you have a workplace retirement plan, such as a 401 or 403, theres most likely to be only one target date fund series from an investment managersay, Vanguard, Fidelity, or BlackRock. Your choice is limited to picking the target date fund whose target year jibes with around when you expect to retire.
If you have an individual retirement account at a discount brokerage, you may have the option to choose between the brokerages own target date fund as well as target date funds from other firms as well, though there may be an extra fees involved for the latter options.
The Pros Of Target Date Funds
Target date funds have exploded in popularity over the past decade.
About two-thirds of 401 plans offered target date funds in 2007, according to recent research by the Employee Benefit Research Institute and the Investment Company Institute. In 2019, this figure was almost 87%.
Just a quarter of retirement savers used a target date fund in 2007, compared to 60% just 12 years later.
A major reason for these gains is that in 2007, the Department of Labor allowed retirement plan sponsors to automatically enroll employees into target date funds upon becoming eligible for company benefits.
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How Much Does It Cost
Beyond the initial deposit, also consider ongoing fees youll pay. The cost of a mutual fund is known as its expense ratio, an annual fee expressed as a percentage of your investment or, as the name suggests, the ratio of your investment that goes toward the funds expenses. The higher the fees, the more costs can erode total returns.
The average target-date fund had an expense ratio of 0.52% in 2020, according to research from Morningstar. But these fees can range from as low as 0.1% to more than 1.5%, so theres room to shop around. The difference in price often revolves around whether the fund leans on cheaper passive investing strategies or more costly actively managed accounts.
American Funds Target Date Retirement Series
Investments in American Funds target date funds are allocated among a diversified portfolio of stocks and bonds. Investors select a target date fund, typically the one nearest their anticipated retirement date. Over time, that fund’s mix of stocks and bonds will shift toward more conservative investments. This gradual shift over time is called a “glide path.”
Heres how it works:
- Significant stock investments throughout the lifetime of your fund can help manage the risk of outliving your savings in retirement.
- An increased emphasis on bonds as you near your retirement date can help manage the risk of market declines.
- The fund is managed beyond retirement, so you could feasibly use a single fund for decades.
Our objective-based glide path
Although the target date portfolios are managed for investors on a projected retirement date time frame, the allocation strategy does not guarantee that investors’ retirement goals will be met. Investment professionals manage the portfolio, moving it from a more growth-oriented strategy to a more income-oriented focus as the target date gets closer. The target date is the year that corresponds roughly to the year in which an investor is assumed to retire and begin taking withdrawals. Investment professionals continue to manage each portfolio for approximately 30 years after it reaches its target date.
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Vanguard Target Retirement 2040 Fund
The Vanguard Target Retirement 2040 Fund is best suited for investors planning to retire between 2038 and 2042, and its minimum initial investment is $1,000.
The fund was issued on June 7, 2006, and has generated an average annual return of 8.32% since its inception. According to Vanguard, the fund also has an annual expense ratio of just 0.14%. The fund has $33.1 billion in net assets, of which about 80% are held in stocks and 20% are held in bonds.
The Vanguard Target Retirement 2040 Fund is also considered a moderate-to-aggressive fund. However, as with the 2030 fund, the Vanguard Target Retirement 2040 Fund will become more conservative over time as the allocation of assets in the fund change. Similarly, this fund is also best for people who want to invest for 10 years or more.
To Or Through The Target Date
A target-date fund may be designed to take you “to” or “through” retirement. Generally, a “to retirement” target-date fund will reach its most conservative asset allocation on the date of the funds name. After that date, the allocation of the fund typically does not change throughout retirement.
A target-date fund designed to take an investor “through retirement” continues to rebalance and generally will reach its most conservative asset allocation after the target date. While these funds continue to decrease exposure to equities throughout retirement, they may not reach their most conservative point until the investor is well past age 65.
Upon reaching their target dates, some target-date funds merge into different funds that typically focus on generating income. If your target-date fund is merged into another fund, read the new funds prospectus to determine if it is in line with your investment goals and risk tolerance.
In either case, reaching the target date does not mean youve saved enough to meet your goal. Whether or not your retirement savings goals will be met will depend on many factors, including how much you invest in the fund, the funds market performance and other sources of retirement income available to you.
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State Street Target Date Retirement Funds
State Streets 2050 target date retirement fund, ticker SSDLX, makes a strong impression with only a 9 basis point expense ratio. Its one of the least expensive options available today.
Its asset allocation is similar to Vanguards.
The Portfolio tab shows us the fund is invested 51% in U.S. stocks, 35% in international stocks, and about 10% in bonds. The holdings of the fund reveal more similarities to its Vanguard counterpart. It invests the fund in six index funds.
Three stock funds and two bond funds substitute for the inverse with Vanguards offering. The U.S. stock portion of the fund is split into an S& P 500 large blend fund and a mid-cap growth fund. Still, State Streets fund should perform in line with Vanguards, with the added benefit of the lower expense ratio we saw earlier.
- Website: State Street
Are Target Date Mutual Funds A Good Fit For You
Investors who may benefit most by investing in target date funds are those looking for:
- Simplicity. It’s normal to be confused about how to transition one’s asset allocation over time so that it is ready for retirement as the target date gets closer. Target date funds simplify the investment process so investors don’t have to do any research or other investment management. Some investors do not have the desire or the time to learn how to build a portfolio of mutual funds for retirement.
- Diversification. Target date funds are often composed of a diverse selection of mutual funds, making one diversified portfolio in just one fund.
- Automated investing. You’ll set an appropriate asset allocation for a stated retirement date and, over time, slowly reduce stocks and increase bonds. By doing this, the target date retirement fund does all of the asset allocation and investment selection for you.
- A one-fund solution. Target date funds can be considered an all-in-one retirement planning solution. The most ideal candidate for target date retirement funds is the investor who has most or all of their retirement savings in one account, such as a 401 or IRA.
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The Smart Way To Use Target Date Retirement Funds
All the best research we have on investing says that a diversified portfolio of low-cost index funds is likely to outperform 80-90% of other investment strategies.
Simply put, index investing gives you the best possible chance of reaching your long-term goals.
And in theory, target date retirement funds or really any all-in-one fund can make it as easy as possible to put that research into action.
Target date retirement funds do the heavy lifting for you, combining multiple mutual funds covering both US and international stock and bond markets, giving you the luxury of contributing to a single mutual fund that requires almost no ongoing management and, if constructed correctly, should deliver superior results.
Really, its no different than what automated investment platforms like Betterment have introduced in recent years. In both cases, theyre simply giving investors access to high-quality, all-in-one portfolios that make the entire investment process a whole lot easier.
But not all target date retirement funds are good, and even the good ones can lead you astray if youre not careful.
So before you put all your money into a target date retirement fund, its important to understand what the potential weaknesses are and how to use them in a way that actually increases your odds of investment success.
Lets get into it!
Why Consider Target Date Funds
Target date funds make it easy for people looking to save for retirement to potentially maximize their future retirement income. If you have a 401 plan, you may already be invested in a target date fund, since many plans use them as their default investment. Depending on your retirement goals, there are several investment strategies you can consider when getting actively involved in selecting a target date fund.
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Vanguard Target Retirement 2030 Fund
The Vanguard Target Retirement 2030 Fund is designed for investors who wish to retire between 2028 and 2032, and its minimum initial investment is $1,000.
The fund was issued on June 7, 2006, and has achieved an average annual return of 7.68% since its inception. Its expense ratio is 0.14%, which is 69% lower than the average expense ratio of similar funds, according to Vanguard.
As of May 31, 2021, the net assets of the fund were $41.9 billion, of which about 65% were held in stocks and 35% in bonds. The fund had a 17% annual turnover ratio in the 2020 fiscal year.
The Vanguard Target Retirement 2030 Fund is considered a moderate-to-aggressive fund. However, the allocation of assets in the fund will change as the target date approaches, and it will become more conservative over time. This makes the fund most suitable for people who want to invest in it for 10 years or longer.
Rash Of Recent Lawsuits Focus On Blackrock Indexed Target Date Options: Even Low
DYLAN RUDOLPH and JOSEPH FAUCHER, September 29, 2022
Over the past several weeks, a single law firm, Miller Shah, LLP, has filed nearly a dozen lawsuits against fiduciaries of defined contribution plans that offer the BlackRock LifePath Index target date funds . The cases represent a shift in approach relative to earlier waves of ERISA litigation. While cases in this area have largely targeted investment options that plaintiffs claimed were overpriced actively managed funds, the BlackRock Funds are passively managed funds tied to mutual fund indices, and, as a result, carry lower overall expense ratios relative to their actively managed cousins.
What has become colloquially known as excessive fee litigation has proven to be both stubbornly persistent and consistently evolving in fact, that name itself may need to be revisited now that even low-cost indexed funds are in the plaintiffs crosshairs. For almost two decades, these excessive fee lawsuits have been filed against fiduciaries of defined contribution plans throughout the country, asserting that plan fiduciaries selected investment options which were both overpriced and poorly performing, among other claims. One frequently repeated theory of liability in those cases was that actively managed investment funds did not perform well enough to justify their higher investment management fees and, therefore, should have been removed from a plans investment lineup.
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What Are Target Date Funds
Target date funds invest in assets which match the recommended risk preferences of investors with their intended retirement date.
Depending on the age at purchase, the mix of underlying assets can comprise various allocations toward stocks and bonds.
Please note all funds are not the same. Most follow a similar strategy:
However, despite these simple steps, these funds can differ dramatically.
This includes the investments held in each fund, various levels of fees associated with the fund and underlying investments, and even what happens with the investments from present to target date and beyond .
In fact, some funds cease the transition to more conservative investments at the target date while others transition slower and continue shifting toward more fixed-income/cash allocations.
The advantage of the latter would be more potential for growth into your retirement years.
For target date funds to qualify as one of the best investments for young adults, Id only consider the latter since continued portfolio growth in our later years is important.
I say this because as things currently stand, we might not have as many retirement resources as our parents and grandparents with Social Security and Medicare currently slated to run out of money before we retire.