Target date funds (TDFs) represent a quarter of retirement plan assets in the United States, and 80% of 401(k)-style plans offer target date mutual funds and exchange-traded funds, according to the Retirement Plan Sponsor Council of America. Their popularity has exploded partly because employers use them as the default investment for employees who join 401(k) plans without making an investment selection. Here's some important information for you to consider before you jump on the TDF bandwagon.
For many people, it makes sense to invest in a portfolio that evolves over time from a more aggressive asset allocation to a more conservative one as the investor nears retirement age. That way, they can invest without the hassle of managing their portfolio over the years. But not all TDFs are created equally.
By design, TDFs aren't necessarily intended to shield investors from investment volatility, particularly those at least a couple of decades away from retirement. Moreover, returns on a TDF's stock allocation — because it often covers a wide range of stocks, including foreign stocks — might not meet the expectations of investors who expect it to mirror a familiar benchmark like the S&P 500 or tech-heavy NASDAQ.
To avoid unpleasant surprises when investing in TDFs, it's important to conduct due diligence on the options offered by your plan and monitor how the fund performs. TDFs generally can be divided into two competing "glide path" philosophies:
Today, only about 10% of TDF dollars are invested in funds employing a strict "to" strategy. Over time, it seems, the logic of the "through" model has prevailed. Ultimately, your risk profile and personal circumstances determine which of these two glide paths are right for you.
For example, suppose you want your 401(k) plan assets to provide a stable base to offset other investments in more volatile assets, particularly those that will likely keep up with inflation over time. (Remember, inflation generally erodes the value of ultra-secure assets like short-term bonds.) In this situation, a "to" TDF might be appropriate.
Conversely, if nearly all of your retirement savings are tied up in your 401(k) plan, a "through" TDF might make sense, assuming you're comfortable with any kind of TDF in the first place.
In addition, TDFs with similar models can wind up with significantly different asset allocations at the target date. For instance, one "through" TDF might hold 60% of its portfolio in stocks at the target date, and another "through" TDF might hold only 40% in stocks at the target date.
These distinctions can translate to significantly higher returns over time. For example, the 10-year average annual returns as of August 31, 2021, for two of the largest 2030 funds, were 10.29% and 9.63%. Over a decade, the higher-performing fund (if you froze contributions at the starting point) would be worth 6% more than the lower-performing one. That extra return could add up to serious dollars in a retirement fund.
Investors also need to focus on how different TDFs within the same glide path are invested. This is particularly true of the stock (equity) component. Remember that all stock classes don't move in lockstep.
Over a 35-year period, using exchange-traded funds issued by one of the nation's top investment companies as a proxy for the performance of individual stock categories, wide variations by asset class emerge. For example, in 2010, U.S. small cap stocks rose by 26%, but large cap stocks were up only 13.4%. However, in 2014, average returns on large cap stocks were double those of small cap stocks.
Variations between non-U.S. stocks and domestic stocks can be even more dramatic. For example, when stock sector averages were down across the spectrum in 2018, international stocks fell twice as far as large cap U.S. stocks.
The varying rates of volatility among different stock categories highlights the importance of looking not only at the breakdown of a TDF's stock allocation, but also how it changes over time. In general, you'd expect a fund with a more volatile stock class to taper down its risk profile sooner than a fund with less volatile stocks. For example, one major TDF provider considers so-called "high-beta equities" the key to early-stage growth, but its funds tend to shy away from high-risk investments as the fund nears its target date.
Your company's 401(k) plan may offer limited TDF options. If the only TDFs available to you don't appear to meet your needs, remember that you may have an unlimited number of choices within an IRA or a regular nonretirement investment account. Your professional advisors may be able to help you work through your options to find the best solution based on your situation.
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