Keeping Your Eye on Your Target-Date Fund

It would certainly be nice if saving for retirement were as simple as setting a date, pointing your investment account in the right direction, and walking away for a few decades, returning to find everything ready when you needed it.

Target-date funds have rapidly gained popularity because they promise to take investors to retirement and beyond, while removing the hassles of dealing with asset allocation, portfolio rebalancing and interest rate risk. But can they really make things that simple?

Yes, but only to a point. While these funds have their uses, investors need to stay active in planning for their retirement. One-size-fits-all will never fit any one person quite as well as something tailored, whether it’s a three-piece-suit or a retirement plan.

You can think of a target-date fund as a wrapper that holds investments in several underlying mutual funds or exchange-traded funds (ETFs) within a single security. The fund is tied to a date in the future, usually presumed to be the fund holder’s projected year of retirement.

At regular intervals, the fund is automatically adjusted between different holdings to reflect market behavior and to reduce exposure to riskier assets (usually stocks) as the retirement date approaches. This change in allocation is called the fund’s “glide path” and is designed to reduce the potential harm of a big market downswing close to an investor’s retirement date that leaves too little time to recover.

There are several reasons these funds have become popular so quickly. First, target-date funds are convenient, because they allow investors to gain access to several asset classes within a single fund. A level of diversification is built in. These funds can take some of the stress out of having to actively manage a portfolio, which can make them attractive investments for those who do not have the time or the inclination to manage their own portfolio but who lack the resources to hire an investment adviser directly.

Another contributing factor to the funds’ popularity is the safe harbor rules created under the 2006 Pension Protection Act, which made target-date funds a qualified default investment for 401(k) plans with automatic enrollment. Many companies now use the funds as the default choice for their employees, who often find inertia simpler than making an active decision about their investments.

Target-date funds are not a panacea, however. Many of these funds come with features that should make investors should be wary. One is cost. The overall expense ratio may simply be a weighted average of the management fees of the underlying funds, or the fund operator may charge an additional fee on top of the underlying funds.

A major factor in the overall cost is whether the fund is made up of index or actively managed funds. Index funds tend to charge lower costs than actively managed funds because they just track a benchmark and require less oversight. Managers of actively managed funds strive to beat their respective benchmarks by adjusting the fund’s portfolio based on their interpretation of market conditions. Because of more manager oversight, these funds tend to have higher management and administrative costs. As with other 401(k) or investment account fees, investors should be sure they know what they are paying for.

Some investors also perceive target-date funds as inherently safe investments, or worse, as guarantees of having enough for retirement. In reality, different funds offer very different levels of risk. Further, many target-date funds take as a given that bonds are safer than equities, and so will weight bonds more heavily as the investor approaches the fund’s target date.

Given the current low interest rate environment, the margin of safety offered by bonds over equities is not so clear-cut. Future rises in interest rates will mean lower bond prices. The impact of the changing rates will depend on the duration of the bonds in the fund. In general, bonds with a longer time to maturity will see greater price declines as rates rise.

How much damage investors will suffer as a result of rising rates will depend on how quickly and how high rates rise, as well as the composition of the particular fund’s bond investments. Funds with higher allocations to long-term bonds will see larger losses than funds that have shorter-term bond holdings. Those who happened to retire during 2008 or 2009 faced a stock portfolio battered by the recession; retirees who invest in target-date funds that take the safety of bonds as a given may soon find themselves in a similar situation.

Besides understanding the general risks of target-date funds, investors should be aware that not all such funds are the same, even if they have the same target year. Each fund family has its own philosophy regarding which asset classes (for example, commodities or real estate) should be included in its target-date fund lineup, how frequently the fund will rebalance, and when and how quickly the fund will shift to investments that are more conservative. If investors do not understand their fund family’s strategy, they could easily find themselves invested in a fund that is not appropriate for their situation.

Investors should also understand that the proper fund for them might not be the one targeted for the year they expect to retire. For example, individuals with a higher risk tolerance might prefer to maintain a higher weighting to stocks through retirement. They should consider investing in target-date funds with a date later than their expected retirement year (such as 2030 instead of 2020).

Target-date funds typically have higher exposure to stocks the further they are from their target year, so choosing a date farther in the future tends to preserve a higher level of stocks and potentially higher returns. It is also important to realize that some funds aim to reach their most conservative level at their target dates, while other funds may not shift to their most conservative allocation until years later. This all depends on the philosophy of the fund operator. It is essential to ensure the selected fund matches the investor’s goals.

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