Target Date Funds: Always Look Under the Hood

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By J Kevin Stophel, a financial advisor on NerdWallet’s Ask an Advisor.

Many investors seek a way to invest their capital wisely with a limited need for ongoing maintenance. Target date funds (TDFs) have been developed to satisfy just this need. But consumers typically do too little homework before selecting this particular kind of mutual fund.

TDFs are attractive to many investors who don’t want to constantly manage their investments. These funds automatically rebalance to a “proper” investment mix that grows more conservative as one gets closer to retirement (the target date). But many consumers don’t really examine the selected TDF after making the initial purchase. Instead, most people pick a TDF that matches their retirement date, pick a well-known mutual fund company such as Vanguard, Fidelity or T. Rowe Price, and check the historical returns.

But that’s like buying a shiny new automobile without understanding what’s really under the hood.

Target date funds, also known as lifecycle funds, are a fairly easy concept for a novice investor to understand. An investor who is planning to retire in 2030 at age 65 would pick a 2030 target fund. As that individual gets closer to retirement, the fund’s managers would rebalance the fund’s holdings—commonly including stocks, bonds, cash and other assets—toward a more conservative investment mix.

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This changing allocation model is known as the fund’s “glide path.” A TDF may be configured to model an allocation either “to” retirement or “through” retirement.

The target date of a “to” fund is the point at which the investor is expected to need the money. The “through” fund is built to continue to adjust towards a more conservative allocation after the retirement (or target) date.

The basic idea is that an investor won’t need all the money at the target date, so he or she will need to stay invested throughout their retirement years. This can lead to a significantly higher allocation to stocks at the target date as the management company may plan on the fund being at its most conservative mix a decade or more past the retirement date.

The differences in the glide paths are one reason the returns of 2010 TDFs ranged from -5% to -30% in 2008—which is a staggering difference. For those in “to” funds who were down 5% in 2008, the Great Recession may not have been a disaster. But for those who were invested in a “through” fund and were down 30%, it may have felt like the end of the world.

A common error of investors is looking at total return estimates for the fund without considering whether it is a “to” or “through” TDF.

In addition, TDFs can vary dramatically in cost. Some funds have sales loads, which are commonly used to pay commissions to brokers, either at purchase or when selling the fund before a required holding period is up. Other fees and expenses can be built into the TDF as well and need to be considered. At least one level of management fees will be embedded in a TDF, and it’s very common for there to be two levels of management fees. Many TDFs are a combination of other mutual funds that are packaged together and presented for purchase as a single investment. In such cases, each individual fund in the TDF will have a management fee and the TDF overlay manager (the manager who keeps the funds properly allocated between the TDF’s utilized mutual funds or ETFs) will charge a management fee as well.

In addition, other fees may be charged related to rebalancing the investments, trading, asset allocation, special investments or transfer agent fees. If the expense ratios of the underlying funds are less than the overall fee of the TDF, do your homework and find out what the additional fees represent as the differential fees may be frivolous and not worth paying.

When it comes to TDF construction, some are made up of proprietary family funds while others use funds from multiple fund families. Neither is necessarily better or worse, they’re just different approaches to fund construction. It is common to hear proprietary funds tout lower overall fees while it is common to hear multiple family funds tout access to “best-in-class managers.” But the reality is that not all proprietary fund TDFs have lower fees and not all multiple fund family TDFs have “best-in-class” managers either.

Importantly, understand your required investment return relative to the TDFs expected return. Although TDFs are easy to use, that doesn’t necessarily mean they will meet your investment needs. If you need your investment to average 8% per year to reach your retirement goal and you are 55 years old and investing in a “to” TDF with a target date 10 years in the future, you will most likely be sorely disappointed. Such an investment may only be structured to generate an expected return of 5%, which is significantly lower than your goal.

Even though TDFs are easy to use, they shouldn’t replace common sense investing and should never be used without first understanding whether or not a selected TDF has a realistic chance of getting you where you want to go.

As with any investment, be sensible and do your homework before investing. Don’t buy sizzle, buy substance. To evaluate substance, read the fund prospectus and gain an understanding of what you can realistically expect from the TDF and determine if it matches your needs. To make sure you have a quality engine to get you where you need to go—always look under the hood!



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Personal Finance , Retirement , Investing Ideas , Mutual Funds

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