As a retirement saver, you may have heard of a target date fund as an option in your company’s retirement plan. These investment vehicles are gaining traction on an industry-wide scale, harboring nearly $0.70-$0.80 of every dollar invested into retirement plans today. The likelihood that some version of these funds are available in your company’s retirement plan is high. So, what are they, and why are they becoming the go to strategy for so many retirement savers?
What is a Target Date Fund?
A target date fund is a single investment option, made up of several underlying investments, that aligns your investment allocation with your age and intended year of retirement. In general, most retirement savers maintain an “aggressive” investment allocation at a younger age, and a more “conservative” allocation closer to retirement. Someone who is 40 years away from retirement is afforded the luxury of time, while someone who is five years away is not. A target date fund takes this philosophy into consideration and invests accordingly, ultimately helping investors grow their retirement savings during their earning years and provide income and stability in their retirement years.
A target date fund is often broken down by its proportion of stocks and bonds. Earlier in a target date fund’s life cycle, the fund will invest a significantly higher percentage in stocks compared to bonds – for example, 95% stocks and 5% bonds. As the investor approaches retirement, the ratio of stocks to bonds will automatically decrease along a glidepath that mirrors the investors intended risk profile. At retirement, the proportion of stocks to bonds in a target date fund could be as low as 40% stocks and 60% bonds. The key word in this example is “automatically.” A target date fund is run by a professional investment manager, and it is that manager’s job to reallocate the money to reflect the appropriate stock to bond ratio on your behalf. No action is needed by the investor to follow the fund’s glidepath, making this an easy “set it and forget it” option for retirement savers.
A target date fund series is typically broken out by various “vintages” which identify the estimated retirement year. For example, a target date 2045 fund can be utilized by someone who expects to retire in the year 2045. A full target date fund series contains multiple funds covering a wide range of estimated retirement ages.
Due to the automatic asset rebalance that occurs, many retirement plans have adopted target date funds as the plan’s Qualified Default Investment Alternative (QDIA). A QDIA is the default investment investors are placed into if the investor does not select an investment option on their own. The U.S. Department of Labor has released statements providing guidance on the acceptance of TDFs as a plan’s QDIA, thus further increasing the popularity of these funds.
Pros and Cons to Target Date Funds
As with any investment, target date funds have their own pros and cons. The primary advantage is the “one stop shop” and “set it and forget it” nature of these investments. Instead of selecting several investments to help investors reach their retirement goals, an investor can select one target date fund that corresponds with their estimated retirement age. Retirement savers can often be weary of investing in only one fund, as opposed to a diversified portfolio of multiple mutual funds. However, a single target date fund is, by design, properly diversified as the underlying composition of the fund is a combination of stocks, bonds, and other asset classes based upon your investment time horizon. Additionally, investors can rest assured that the target date fund will automatically rebalance and align with their retirement goals as they get closer to retirement and won’t need to make any portfolio changes themselves.
Contrarily, a target date fund may not be appropriate for an investor whose risk profile and/or retirement savings goals are different than the “standard” for someone in their age group. Target date funds take only an investors’ age into consideration when determining the asset allocation. For example, let’s compare a 40-year-old executive of a Fortune 500 company and a 40-year-old mid-level employee. The same target date fund may not be appropriate for both investors as both participants likely have different levels of income, retirement goals and standards, outside investment vehicles, and established nest eggs. Thus, a target date fund may or may not be appropriate for those individuals based on their own situation. Investors should consider this in determining if a target date fund is right for them.
The Bottom Line
Target date funds have revolutionized the retirement plan industry by providing an ERISA compliant Qualified Default Investment Alternative (QDIA) for investors. As a participant in your company’s retirement plan, it is important to perform your own due diligence on the target date funds in your company’s lineup of investment options. You may find that these funds are an appropriate investment vehicle for you that adequately aligns your retirement portfolio with your goals and risk tolerance. Target date funds are not going away anytime soon, so the more you can learn and understand them, the better investor you will become.
General disclaimer: This information discusses general market activity, industry or sector trends, or other broad-based economic, market, or political conditions and should not be construed as research or investment advice. Views and opinions expressed are for informational purposes only, are current as of the date of this publication, and may be subject to change.