I was recently asked about target-date mutual funds.
What are they? Are they a good investment? And should they be used to save for retirement?
I answered these questions (and more!) on the Stay Wealthy Podcast a few weeks ago.
Here is a Summary of My Key Points:
- Target-date mutual funds are good, not great.
- Not all target-date funds are created equal. Look under the hood to understand exactly what you are buying.
- Costs matter more than just about everything. Choose low-cost target-date funds over high-cost to improve your chances of success.
What is a Target-Date Mutual Fund?
A target-date mutual fund invests in a diversified basket of stocks and/or bonds suitable for a person who wants to retire during a specific year. They are easy to spot because they all have a year in their name.
Take the Vanguard Target Retirement 2025 Fund, for example.
A person looking to retire in 2025 might consider investing their retirement dollars in this target-date fund.
Don’t think you will retire until 2030? You might consider the Fidelity Freedom 2030 Fund.
The further you are from the target date, the riskier the fund is. In other words, a 2030 target date fund is going to carry more risk than a 2025 target-date fund.
As you get closer to the target year, the fund will automatically shift into a more conservative portfolio. It is constantly being rebalanced on your behalf, slowly moving from stocks (the risky stuff!) to bonds (the safer stuff!).
Essentially, target-date funds are “asset allocation mutual funds.” The fund is set up to automatically do all the asset allocation work for you.
They are typically offered in five-year increments, allowing investors to decide whether they want to retire in 2025, 2030 or 2035, and so on.
Why Are Target-Date Funds So Popular?
While target-date funds were invented in the 1990s, they surged to popularity in 2006 after the passage of the Pension Protection Act of 2006. This act, which was signed into law by President Bush, aimed to maintain stronger pension funding rules and increase transparency in retirement plans.
This act ultimately influenced the way 401(k) plans were handled by employers, encouraging them to adopt automatic enrollment features for participants. And really, this is a good thing when you consider the alternative.
Before 2006, a lot of employees who enrolled in a workplace 401(k) plan would forget to choose an investment mix, leaving their money to linger in cash. The Pension Protection Act of 2006 prompted 401(k) plans to automatically move investments into qualified default investment alternatives, or QDIAs.
Because target-date funds are well-diversified and align with a specific retirement year, they have become a popular option for 401(k) plan QDIA options.
This means that, if you enroll in a 401(k) plan and forget to choose an investment plan, there is a good chance your money will be invested in a target-date fund.
Obviously, having your money in a target-date fund should help your nest egg grow more than holding cash and losing money to inflation every day. But, according to 401(k) expert Aaron Pottichen of Alliant Employee Benefits, this doesn’t mean a target date fund is the best option for your retirement goals.
“A company has defaulted you into this fund believing it’s the right investment for you. The administrator of your 401(k) plan has no idea what assets you have, if you have an inheritance coming your way, or any other details about your life. They’ve only put you in a target-date fund based on the year of your birth. For that reason, it’s highly possible the target date fund you’re in may not have the best asset allocation to help you reach your goals.”
What to Look for When Comparing Mutual Funds in Your Retirement Account
As I shared on my retirement podcast, target-date funds aren’t necessarily a bad investment option. You just need to understand that, if a target-date fund has been chosen for you, the factor considered by your 401(k) administrator was the year you were born.
However, I will say this — target-date funds are typically more expensive than allocating your money across a handful of low-cost index funds. This is because they do the asset allocation work for you, including rebalancing.
That being said, you should know that some target-date funds are more active than others.
Active Target-Date Funds Versus Passive
Active target-date funds invest in a basket of actively managed mutual funds. This means they have teams of people who are actively trading your money in an attempt to beat the market.
Passive target-date funds, on the other hand, invest your money into low-cost index funds that track an index, like the S&P 500. This means they can offer lower ongoing costs when compared to their active counterparts.
If you’re unsure whether target-date funds you’re invested in are active or passive, you can usually tell by taking a look at the fund’s expense ratio on Morningstar. Not surprisingly, actively managed target-date funds charge higher expense ratios than passively managed funds.
That’s why, if I were to invest in a target-date fund, the number one factor I would consider is whether the fund is actively or passively managed. This is becayse I would want to pay the lowest cost possible for a fund that matches my retirement goals.
Why Costs Matter When Investing for Retirement
As a financial planner, I have seen with my own eyes how improbable it is for actively managed funds to beat broad market indexes, so what’s the point of paying more?
Plenty of studies back up my observations.
In fact, a very famous academic study published by Vanguard showed that the best predictor of future investment returns is always going to be the underlying cost of that investment.
It’s not that active fund managers are bad at their jobs — it’s that the fees they charge eat away any excess return they are able to uncover.
While costs are one of the most important factors to look for in a target-date fund, here’s everything else you should consider before you choose these funds over other investment options:
- Asset allocation of the target date fund right now: Look up the underlying holdings of the target date fund you are considering to see if the allocation aligns with your goals. Remember that one fund’s idea of “conservative” investing may be different than another’s, and that some may not invest the way you would if given the choice. For example, I prefer to invest a large chunk of my portfolio in international stocks, but some target-date funds are biased towards U.S. Stocks.
- Asset allocation of the target-date fund at retirement: You should also know what the asset allocation might look like for a target-date fund during your retirement year. To do this, you can look at target-date funds from the same custodian for a closer look under the hood. As an example, I looked up the Vanguard 2020 target date fund recently and discovered this fund was made up of more than 50% stocks. If I were planning to retire next year in 2020, that would give me pause.
- Other options available to you: While a target-date fund could easily be your best option within a limited 401(k) plan, these funds may not be the best option if you’re investing on your own at a discount brokerage firm. Make sure to check for other investment solutions that can accomplish your retirement goals at a lower cost.
The Bottom Line
Target date funds are often the default investment for 401(k) plans, but that doesn’t mean they’re the best option for you.
They frequently come with higher ongoing costs when compared to passively managed index funds. Additionally, the underlying investments and asset allocation in a target-date fund may not even make sense for your goals and risk profile.
Before you stick with a target date fund for the long haul, make sure to consider all options available to you. These funds can be a good option if you want to put your retirement on autopilot, but it’s important to understand their pitfalls, too.
