Are Target Date Funds in your 401(k) Plan?

Target date funds have existed since 1994, but have surged in popularity over the past decade.  This can mostly be attributed to the Pension Protection Act of 2006, when target date funds were included in the list of qualified default investment alternatives (QDIAs).  In other words, for employees automatically enrolled in their company’s 401(k) plans, their contributions may be automatically invested into a target date fund unless otherwise specified.  As a result, as of 2016, target date assets have reached $800+ billion in assets.

What is a target date fund?

Target date funds are often thought of as “set it and forget it” funds.  For example, if an employee, age 45, plans to retire in 20 years, he or she might own a target date fund that matches that time frame, with a target of 20 years.  Similarly, target date funds may be offered in 529 plans, where the investments target the time from current age of the beneficiary to the typical college commencement date of age 18.

Once invested, the portfolio manager will manage the asset allocation of the strategy toward the date specified.  The reallocation over a predetermined period to reflect an investor’s changing tolerance for risk is known as the target date fund’s glide-path.

The glide-path sets the fund’s allocation among various asset classes over time, adjusting the mix from more aggressive investments early in the life of the fund to more conservative investments as the fund matures and approaches its target date.

How does an investor or plan sponsor pick a target date fund?

Most 401(k)s will have a pre-selected suite of target date funds available to the plan’s participants.  The investor will simply choose the fund that most closely matches the year in which he/she would like to retire.  The further out the target retirement year, the more aggressive the fund will be allocated at the current time.  David Pilaitis, Apexium Partner and head of its 401(k) practice group, notes that in many 401(k) plans target date funds are the most popular investments, in all likelihood because some participants never deviate from the default investment.

In the case of 529s, usually the state has a predefined suite of target date funds.  Here, the owner will select the fund that matches the current age of the beneficiary.

Something to keep in mind:  An important feature of target date funds is that some are designed to invest up to retirement (“to funds”) and others are designed to invest during, or through retirement (“through funds”). The differences between a “to fund” and a “through fund” can be significant, as a typical retirement can be 20 or more years.

 What are the advantages of a target date fund? 

  • Access to professional money management – When investing in target date funds, the fund manager assumes the responsibility of the allocation of the fund (glide-path). This allows the investor to only have to make a decision on how much they would like to invest in the fund.
  • Low minimum investments – Target date funds allow for instant diversification among, arguably, the two major asset classes, stocks and bonds, starting at only a few hundred dollars.
  • Automatic rebalancing and/or asset allocation change – Target date funds offer a turnkey investment platform to maintain a suitable asset mix to accomplish the investor’s goals.

What are the cons of a target date fund? 

  • Higher expense ratios – Target date funds tend to have higher expense ratios than ETFs and passive mutual funds. In some cases, there is a fee for the underlying mutual funds and another layer of fees for managing the funds.
  • Lack of diversification – Most target date funds only use strategies from their own fund family (Fidelity, Vanguard, etc.). It is rare that one fund family has the “best in breed” strategy for all asset classes (equities, fixed income, and, if included in the asset mix, diversifiers). Recognizing this issue, many fund families have started developing products that include “best in breed” funds, regardless of whether the strategy is proprietary to the fund family.
  • Generic – Target date funds typically invest only in stocks and bonds, or hold cash.  Thus, the investor lacks exposure to a number of important asset classes, such as alternatives, real estate, commodities, etc. However, like the diversification of fund families within one fund, the trend for target date funds has been to include these other asset classes in the glide-path.

With the decline of defined benefit plans, most people are responsible for their retirement. Target date funds can, especially for the busy or unsophisticated investor, be an attractive investment option.

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