Target date funds are a long-term investment strategy where the portfolio asset allocation mix is adjusted, over time, to be more conservative.  While many target date funds are mutual funds, other providers offer target date funds within a defined-contribution plan as collective trusts or separate accounts.

Why Choose Target Date Funds?

•    TDFs offer built-in asset class diversification while avoiding the extremes of too much equity or too much fixed income.  Research shows that asset allocation is one of the most important factors in a portfolio’s long-term performance.

•    Target funds are automatically rebalanced to conform to the fund’s asset allocation model – the glide path.  Over time swings in the market alter the portfolio’s asset mix.  Periodic buying and selling of asset class holdings then readjusts the asset mix back to the fund’s asset class methodology.

•    TDFs provide automatic adjustment for an investor’s changing risk tolerance .  With age comes a shorter time horizon for making up any losses with greater contributions.  Often as an investor ages, the primary focus shifts from accumulating savings to preserving capital.  As accumulated savings balances grow, even small percentage losses can translate into large, unacceptable dollar losses.

•    Using a target date fund to save for retirement is simple and convenient – the industry’s answer for the “do-it-for-me” investor.  To achieve the same benefits of diversification, rebalancing, and a changing risk profile over time an individual investor would have to regularly monitor his portfolio and periodically transfer money between multiple accounts.

What You Should Know About Target Date Funds

First Some Misconceptions About Target Date Funds:

•    The date in the name of a target date fund usually means the date at which the typical investor would reach retirement age and stop contributing to the fund – and not the date at which the investor would cash out the entire account balance.  Generally, target date funds are designed to be your retirement account well beyond a typical retirement date a “through” glide path.  These “through” funds do not reach their most conservative allocation until after the retirement date.

•    A fund with a target date which includes your expected retirement date may not fit your personal risk tolerance.  Most often, choosing a target date before your retirement date will offer a more conservative portfolio, while choosing a target date after your expected retirement date will be a more aggressive portfolio.

•    Lifestyle funds are not target date funds.  Lifestyle funds, which may be labeled “aggressive”, “moderate”, or “conservative”, unlike target date funds, do not change the fund’s asset allocation mix over time.

•    Target date funds don’t guarantee anything – not income, not returns, nor the risk of outliving your money.  The only thing target date funds do is provide professional portfolio management during the accumulation phase of funding your retirement.

Things to Consider When Considering a Target Date Fund

Target date funds are designed as if all of an investor’s retirement assets are held in these funds.  They do not take into account any of the other investment assets an investor may own.  Therefore, an investor needs to be aware of how a TDF affects his total portfolio and possibly reallocate other investment accounts.

Remember that from a total portfolio perspective, tax-wise it is usually preferable to own growth assets in a taxable account and fixed income investments in a tax-deferred account.  Owning a target date fund places both types of investments in a single account, which may not be the optimal tax strategy.

Target date funds are not created equal.  The risk tolerance of individual investors is not equal.  Some target date funds reach their most conservative asset mix shortly after the target date.  For others the glide path continues for 10, 20, or more years.  TDFs use age at retirement as a proxy for risk tolerance.  You should know your personal risk profile and look at a fund that matches your risk tolerance, regardless of the name of the fund.

Shopping for a target date fund requires as much due diligence as purchasing any other investment for your portfolio.  Funds differ in their initial equity allocation, when they start to reduce their equity allocation, when they reach their most conservative equity allocation, and their maximum/minimum equity exposure.  For those funds with a “to” glide path, the priority is to produce immediate income while preserving your assets at your retirement date.  For others – the “through” glide path the highest priority is to continue to grow assets long after your retirement date in order to address the risk of outliving your nest-egg and staying ahead of inflation.  Choosing a target date fund requires doing your homework.  You cannot outsource the selection of an investment appropriate for your financial objectives, goals, and risk tolerance.

Basing your asset allocation mix on your age is an over-simplification.  Your long-term financial plan means you understand your risk tolerance and investment goals.  Not everyone with a 10-year time frame to retirement has exactly the same risk tolerance and financial goals. Participants in an age range may have spouses of different ages and assets outside of the retirement plan ranging from significant to none.  Wealth, current income needs, tax situations, and other factors all impact the asset allocation strategy that is appropriate for a particular investor.

Compare expense ratios for comparable target date funds.  When a target date fund is a fund-of-funds for a single fund family, you are adding layers of fees for managing the funds.  The annual fees for a target date fund are particularly important for TDFs because of the long-term time horizon.  The power of compounding magnifies even small differences over a long time frame.

Have a good understanding of how a particular target date fund works, get rid of your misconceptions about TDFs, consider your total portfolio, and know your financial goals, objectives, and risk tolerance.  Only then will you be in a position to make the right decision for you.