If you're thinking of investing for retirement, you might consider a target-date fund. This is a mutual fund designed for people your age that will favor riskier assets with more growth potential if you're young and will adjust its holdings to be more stable as you age and near retirement.
But before you jump in, take a look at the risks and rewards of investing in one. Not all target-date funds are created equal.
The advantage of target-date funds, or TDFs, is that they make it easy for investors to set-it-and-forget-it when it comes to investing for retirement. But not so fast. If you're not careful, you might end up paying high fees, have your asset allocation out of whack and wind up with less money when you retire than you expected.
"The purpose of TDFs is to remove the thinking of 'how should I invest?'" said Jim Crider, financial planner and CEO at Intentional Living FP. But you could pay the price if you don't pay attention to what your target-date fund owns.
"Any investor should do some amount of due diligence to understand normal expectation for volatility in a portfolio," Crider said. It's up to investors to know how the TDF is invested. And when you change jobs, don't just assume that the TDF at the new job is the same as the one you had before. "Look at the allocation of the fund itself," he said.
What Is A Target-Date Fund?
TDFs were created in the mid-1990s. By 2006 many defined benefit plans like pensions used them to provide an automated solution to prepare for retirement. Since then, their use has expanded to other retirement accounts such as IRAs and 401(k)s, as well as taxable individual accounts.
A target-date fund is a mutual fund with five-year maturity intervals that usually coincide with the age you plan to retire. Retiring in 2030? Just buy the 2030 target-date fund. The fund rebalances its asset allocation during its term to reflect the needs and risk tolerance at that point in someone's life. TDFs start out with a high allocation to stocks and gradually shift to bonds as you get closer to retirement. Some companies also offer income funds you can invest in once you hit that retirement age, to generate the needed income.
Investors love the simplicity of target-date funds. They poured more than $462 billion into the funds in the past 10 years. Net assets in TDFs hit $1.8 trillion at the end of 2021, says the Investment Company Institute.
More than 20 mutual fund companies offer target-date funds. But look more closely and you'll find a large variation in fees, composition and performance.
Most target-date funds are a fund of funds. As such, an investor will likely pay not only the disclosed annual fee on a TDF, but also the annual fees on the underlying funds.
Take for example American Century One Choice In Retirement (ATTCX). It's a target-date fund for people already in retirement. The fund charges 1.75% annually. That's more than triple the 0.57% expense ratio of the average hybrid mutual fund that owns different types of securities, the Investment Company Institute says.
Are Target-Date Funds A Good Idea?
That said, some of the big fund firms, such as Vanguard, wave the fees of any underlying funds. So investors only pay one very low fee of 0.08% for a TDF.
"We're very much an advocate for low-cost investing, always have been," said Brian Miller, a senior investment specialist with Vanguard. "Since we launched our series back in 2003, we've lowered our fees by over 70% over that time. There's no additional cost for the underlying building blocks of the portfolio. The cost you see is the price that you pay."
Ted Benna, consultant at Benna401k and commonly referred to as the "father of the 401(k)" because he created the first 401(k) savings plan, says Vanguard and a couple other firms have very low TDF fees: "0.08%, or 8 basis points — you're not going to invest any cheaper than that."
He believes that "it's bogus that (all) TDFs are expensive. That's being tagged by the fund managers or wealth advisers who can't make money off investments in Vanguard or Schwab's target-date funds."
Disadvantages Of Target-Date Funds
Vanguard says the industry average TDF fee is around 0.49%. Often, investors will end up paying a much higher fee than disclosed by the fund.
"The fees are extremely difficult to determine," Robert Persichitte, financial advisor at Delagify, said. "SEC rules allow target-date funds to hide the bottom layers of fees and only report the fees for the target-date funds," he said.
He gave an extreme example. Let's say you own a fund called Cheap Target Date 2050. Online quote services say its fee is only 0.05%. But that's just the fee of the target-date fund itself. The TDF owns a mutual fund called the Expensive Stocks Fund. And that fund itself has an outrageous fee of 10%.
"The total fees the investor pays are 10.05%," Persichitte said. "First you pay the Cheap Target Date 2050, but then they use your money to pay for the Expensive Stocks Fund."
High fees can dramatically eat into how much money you'll have when you retire.
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Other Factors In Selecting A Mutual Fund
Aside from fees, investors also must look closely at asset allocation.
"Target-date funds change allocation based on a preset schedule (usually called a glide path)," said Joe Marques, wealth advisor and co-CEO at Bolin Creek Wealth Advisors. "In other words, you wake up one day and your fund owns 10% less in (a stock) — not because of the market, not because of valuation or any other reason," he said. It's "simply because the passage of time required the fund to become more conservative (and own a greater allocation of bonds) as the target-date approaches."
That is because most target-date funds focus on strategic vs. tactical allocation.
"The key thing to remember with TDFs is that the investment time horizon is very, very long," said Vanguard's Miller. "It's not measured in years; it's typically measured in decades. If you look at some of the work that we've done and some of the work within the industry, over 90% of long-term returns and the return variability is driven by the strategic asset allocation."
He says that even when the tactical moves are beneficial in the short term, they tend to wash out over longer periods of time.
Retirement Planning Help Might Still Be Needed
Miller says that if an investor owns more than one target-date fund or mixes a TDF with other investments, it might be time to seek professional advice. This helps avoid having an allocation that is not appropriate for that investor's risk-return profile.
Don't forget to review IBD's list of Best Mutual Funds, or find a TDF that owns them, if available in your account.
"Even though several funds may all have the same target retirement date, their underlying investment exposure can vary widely," said Matthew McKee, principal at Target Rock Wealth Management. "Looking at a couple of randomly selected 2040 funds, the 1290 Retirement 2040 (TNNIX) has nearly 21% allocated to fixed income, while Fidelity Freedom 2040 (FFFFX) has 13.7%."
He also notes differences in investment exposures within asset classes. For example, among bonds, maturity and credit quality will vary. Within stocks, market cap, geographic exposure and other factors will change. "And each fund can also differ in its glide path — how it shifts its exposure as the retirement date approaches," he said.
"Inexperienced investors may think that the target-date funds will just help them reach their retirement goals by itself," said Kristy Jiayi Xu, founder of Global Wealth Harbor. "The target-date funds are not customized to the investors' specific situation and basically imply that age is the only factor that determines the portfolio mix."
A Target-Date Fund Can Serve A Purpose
Benna, the 401(k) consultant, believes, however, that the asset allocation of many target-date funds "is pretty much the same as what the professional advisors in managed accounts use." He added: "If I go to a wealth manager to pay a much higher fee, most of them stick me in a prepackaged allocation of funds which are very similar to TDFs."
Further variations lie in active vs. passive funds and their fees. Schwab Target Funds blend both active and passive strategies. Their all-in fees vary between 31 and 69 basis points. Schwab Target Index Funds use only a passive strategy and have an across-the-board expense ratio of just 8 basis points.
The bottom line is that investors need to do their homework to understand what they are getting into.
"For most novice investors — people that really don't have the resources, the time and expertise to do their own portfolio allocation — it's a lot better than what you would likely end up doing on your own," said McKee. "I think Vanguard and BlackRock provide great solutions — it's this idea of the low-cost, passive investing. You're really just getting the broad asset allocation roughly lined up, and it's transitioning over time."
But anything beyond this standard approach might require professional help.
Target-Date Funds With The Highest Fees
It pays to look at costs
| Name | Ticker | Expense ratio |
|---|---|---|
| American Century One Choice 2040 C | ARNOX | 1.83% |
| Fidelity Advisor Freedom 2040 C | FCFFX | 1.75 |
| Fidelity Advisor Freedom Blend 2040 C | FHZEX | 1.54 |
| BlackRock LifePath Dyn 2040 Investor C | LPCKX | 1.47 |
| American Century One Choice 2040 R | ARDRX | 1.33 |
| Fidelity Advisor Freedom 2040 M | FTFFX | 1.26 |
| Franklin LifeSmart 2040 Ret Trgt C | FLOLX | 1.25 |
| Allspring Dynamic Target 2040 C | WTDCX | 1.22 |
| American Funds 2040 Trgt Date Retire R2 | RBKTX | 1.11 |
| T. Rowe Price Retirement 2040 R | RRTDX | 1.11 |
