What Is a Target-Date Fund? (And What to Look for)
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What Is a Target-Date Fund? (And What to Look for)

Let’s face facts, building a portfolio can be a complex undertaking. There are plenty of moving parts such as asset classes, stocks, bonds, correlations, etc. — it can be enough to make your head spin. For many people saving for retirement — especially those with zero financial interest or time to do research — it can all be too much to handle.
Which helps explain why there are now over $1.1 trillion in assets invested in so-called target-date funds (TDFs). That’s a 280% increase in just under five years. A full 88% of 401(k) and similar retirement plans now offer a TDF option among their investment choices and roughly 64% of plan participants hold a position in such a fund.

But what exactly are they? How do they work? And perhaps more importantly, are they a good fit for your portfolio?

All About That Glide Path

The growth in target-date funds can be summed up in one idea: removing the complexity from building a diversified portfolio. To accomplish this goal, TDFs own a variety of stocks, bonds, cash and other assets within one ticker. They basically take a lot of the guesswork out of investing for retirement (or other goals) and offer instant asset allocation. However, unlike life-cycle or target-risk funds, which have static diversified portfolios based on risk-profiles, target-date funds have a unique feature that sets them apart called a glide path. This helps explain why they are a popular retirement investment.
Over time, the target-date fund’s underlying mix of stocks, bonds and cash will gradually shift according to the fund’s investment strategy, following a distinct path set forth by the fund sponsor. By following this glide path, as the investor gets closer to the target date — often the year he or she will retire — the portfolio will become more conservative.

Typically, a TDF will swing from a portfolio mix containing a lot of stock investments in the early years, to a mix-weighted portfolio of bonds and cash later. The further out the target date, the more aggressive the fund will be. Conversely, the closer the target, the more conservative the fund will be.

The problem with glide paths is that not every one is the same. Each fund sponsor has its own unique take on just how much in stock, bonds and other assets an investor should have at each stage of life. However, even with this, target-date funds not only provide instant diversification, but diversification that changes as risk profiles decrease.

“To” vs. “Through”

So a target-date fund will shift to more conservative investments by a certain date. But what happens when it hits that date? Like the difference in glide paths, fund sponsors have a difference of opinion on this front as well. It’s called “to” or “through” and it can mean a big difference to your total returns and goals.

A “to” fund is designed to get you to that target date. The fund will be at its most conservative then and hold that allocation forever. The idea is that the investor in the target-date “to” fund will use the pot of savings all at once or transfer to another vehicle for continued income generation.

A “through” fund will hit retirement — or the target date — with slightly more exposure to equities and continue to become more conservative until about five or ten years after retirement. The idea here is that investors will still need plenty of growth to power them through their golden years. Investors can start withdrawing from the fund while still getting some sort of actual return.

Other Considerations

Understanding the glide path isn’t the only thing investors need to know about TDFs. There are other considerations as well — for one thing, fees.

Target-date funds accomplish their asset allocation goals by investing in other mutual funds sponsored by the same firm. There are two kinds of fee structures at play here. One is called a “roll-up” fee structure in which the expense ratio listed on the target-date fund is what investors will pay. It includes a small management fee plus the expense ratios for all the underlying mutual funds it holds. These TDFs are often the lowest cost available. However, some funds don’t use that structure and essentially “double dip” on their fees. All in all, many quality low-cost, target-date funds can be had for less than 1% in roll-up fees.

Investors also need to look at just how the fund is diversified. If a target fund owns several chronically underperforming actively managed funds, all the diversification in the world isn’t going to save it. Conversely, the target date funds from Vanguard only have four holdings, but provide access to every stock and bond across the globe.

A final thought on TDFs also comes down to risk. Target-date funds assume that risk profile is tied to age. But that may not be true for you. An individual investor may or may not want to dial up or dial down their risk exposures. To that end, choosing a later or earlier dated fund could be a better bet.

The Bottom Line

Target-date funds have exploded in popularity — and with good reason. They offer ever-changing diversification until investors reach retirement age or their target date. They basically take the guesswork out of crafting a diversified portfolio across numerous asset classes.

That said, TDFs are not foolproof.

Investors still need to do their research before pulling the trigger on any target-date fund. There’s plenty of factors that need to be considered.

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Sep 16, 2015