Target Date Mutual Funds

Imagine a single investment that automatically adjusts its risk level as you get closer to retirement. That's the basic idea behind target date funds, one of the most popular options among those saving for retirement. In fact, target date funds are the default option of many employer-sponsored retirement savings plans.

But are they the right fit for your retirement strategy?

What Are Target Date Funds?

Target date funds, often referred to as lifecycle funds, are mutual funds tied to a specific year in the future - your retirement year. So, if you plan to retire around 2050, you might choose a "Target Date 2050" fund.

The key feature of these funds is their glide path - a strategy that gradually shifts the fund's allocation over time.

Early on, when you're younger and have time on your side, these funds lean heavily into stocks, aiming for maximum asset growth. But as the years pass and you get closer to that target date, the fund automatically transitions toward a more conservative mix, moving into bonds and cash equivalents to protect your nest egg from market swings.

For example, a Target Date 2050 fund might start with 90% stocks and 10% bonds. By 2050, that allocation could shift to something like 40% stocks, 50% bonds, and 10% cash equivalents. The idea is that the fund does all the hard work for you, rebalancing your portfolio automatically as you age.

This automatic rebalancing is one of the biggest selling points of target date funds - buy it and forget about it until retirement. With professional management baked in, target date funds offer a solution that may be ideal for novice investors or those looking for a hands-off investing option.

But simplicity isn't the only thing that matters. And there can also be significant differences between funds with the same target date.

Understanding the Fund's Glide Path

It's essential to understand how the glide path of a target date fund works. Some target date funds aim to hit their most conservative point by your retirement date - these are called "to retirement" funds. Once the date arrives, they stop adjusting their asset mix. On the other hand, "through retirement" funds continue to evolve after you retire, gradually reducing risk for several more years.

Why does this matter?

If you plan to leave your money invested after retirement, which many people do, you'll want to understand how much risk your fund is still taking even after you stop working. A "through retirement" fund might give you a smoother landing, but it could also expose you to risk longer than you'd like since a portion of your savings continues to be invested in stocks (and exposed to stock market fluctuations).

One Size Doesn't Fit All

Here's where it gets tricky. Target date funds take a one-size-fits-all approach based solely on your expected retirement year. They don't consider your risk tolerance, financial situation, or specific retirement goals.

Two people planning to retire in 2050 might have very different financial pictures. One might have a pension and be comfortable with more risk, while the other may rely solely on personal savings and prefer a more conservative approach. A Target Date 2050 fund would treat both investors the same way, which may not always be ideal.

Another factor to consider is that target date funds don't protect against sequence of returns risk. This is the risk of withdrawing money during a market downturn early in retirement, which can negatively impact your retirement income. Even with a more conservative allocation near retirement, target date funds don't fully eliminate this risk - they can reduce it but can't erase it.

For those concerned about a market downturn as retirement approaches, one strategy is to divide your savings into different "buckets" based on when you'll need the money. For example, one bucket could be for the first five years of retirement and include investments protected from market swings. Another bucket could be for years six through ten, which may offer some stock exposure, and so on.

Again, with target date funds, all your money is in the same bucket, regardless of your personal risk preferences.

What's Inside: The Underlying Investments

One aspect that often goes unnoticed is what's inside the target date fund - specifically, the underlying investments. When you buy a target date fund, you're not just buying one fund - you're purchasing a collection of other investments. The underlying funds might be a mix of actively managed mutual funds or low-cost index funds. And this is where things can get interesting.

Some target date funds invest in proprietary mutual funds created and managed by the same company offering the target date fund. These proprietary funds might carry higher fees versus low-cost index funds. For example, some funds use actively managed strategies, which tend to come with higher costs but aim to outperform the market. Others may take a passive approach, using index funds to keep expenses low while aiming to match market returns.

The target date fund's investment philosophy also plays a big role. Some companies take a more aggressive approach, keeping a higher stock allocation even as the target date nears, while others might be more conservative. These differences mean two funds with the same target date could have very different risk profiles.

When considering a target date fund, it's crucial to look beyond the target date. Examine the fund's glide path, the underlying investments, and the fees associated with the fund. If a fund invests in high-cost, actively managed mutual funds, you may be paying more in fees but not getting much more in terms of performance.

The Fees: What Are You Really Paying?

Speaking of costs, let's dig a little deeper. One of the main downsides of target date funds is the expense ratio - the annual fee you pay for management. While target date funds offer convenience, that convenience isn't always cheap.

For example, a fund with an expense ratio of 1% compared to one with an expense ratio of 0.1% can lead to a very significant difference in your final account balance over 30 or 40 years. And when you combine the fees from the target date fund and its underlying funds, the total cost can climb even higher.

So, while target date funds offer simplicity, make sure the fees you're paying are worth it for the value you're getting. Since you're paying for convenience and professional management, make sure the fund's fees and investment approach align with your investment goals.

Are There Alternatives?

If you decide that a target date fund isn't the right fit for you, there are alternatives. One approach is to build your own diversified portfolio using low-cost index funds. This approach gives you more control over your asset allocation. It allows you to adjust your portfolio based on your personal circumstances, not just your age.

Another option is a balanced fund, which holds a fixed mix of stocks and bonds. However, you'd need to manually shift to more conservative investments as your risk tolerance changes as you approach retirement.

Working with a financial advisor is another alternative, especially if you want a more personalized strategy. While this typically comes with higher costs, a tailored plan can align more closely with your financial situation, risk tolerance, and specific goals. You can help mitigate those costs by working with an advisor paid on an hourly basis versus an annual percentage of your assets.

The Bottom Line

Target date funds offer a convenient, hands-off way to save for retirement, providing professional management, automatic rebalancing, and built-in diversification. But they're not perfect for everyone. The one-size-fits-all approach may not match your personal risk tolerance or financial goals, and the underlying investments and fees can vary significantly between providers.

Before choosing a target date fund, examine its glide path, underlying investment strategies, and fees. If simplicity and automatic adjustments appeal to you, a target date fund could be a great fit. But if you want more control over your portfolio or a more personalized approach, you may want to explore other options.