How to Use Target-Date Funds
Target-date funds were designed to offer investors a passive approach to investing for retirement and are growing in popularity.
The majority of people who opt to add target-date funds to their portfolios choose the date that is close to the year of when they expect to retire, but others pick a later time frame. In fact, choosing a later target date can be beneficial.
Gary Lemon, a professor of economics and management at DePauw University, for example, chooses 2060 as his target date, even though that's well passed his expected retirement age because the percentage of stocks is higher in this fund.
Target-date funds are intended to give people the option to invest in a broadly diversified portfolio, which allocates assets automatically into more conservative ones such as bonds as they approach retirement age.
As many people are working longer and living into their 80s and 90s, a typical target-date fund based on an anticipated retirement age based on retiring in their 60s may not work as well for that reason. So picking the right target date comes into play.
Here are few things to know about including a target-date fund in your portfolio:
-- Funds may not have enough stock allocation.
-- Expense ratios are higher than some index funds.
-- Investors should review their portfolio strategy.
-- Target funds may miss a bull market.
Funds May Not Have Enough Stock Allocation
Target-date funds move into a more conservative mix of corporate and municipal bonds as a person's retirement date is approached. Since these funds are diversified, including one "may be all that an investor requires for their retirement portfolio," says Stuart Michelson, a finance professor at Stetson University.
The Vanguard Target Retirement 2065 Fund (ticker: VLXVX) allocates 90% to stocks and 10% to bonds, compared to the Vanguard Target Retirement 2025 Fund ( VTTVX), which aims to hold about 65% stocks and 35% bonds, "showing that the near-term target date is more conservative, investing more in fixed income investments," he says.
[See: 8 Simple Rules for Investing in Retirement.]
At the time of this writing, the one-year, after-tax returns for the Vanguard target date funds of 2025, 2035 ( VTTHX), 2050 ( VFIFX), and 2065 are similar at slightly more than 3%, while the expense ratios range from 0.13% to 0.15%. The average one-year annualized returns among these funds vary from -0.45% for the 2065 fund to 1.82% for the 2025 fund.
Alternatively, instead of choosing a target-date fund that is slightly older than your age of retirement to overweight the equity portion of your fund, an investor can opt for a slightly better strategy that would also add more diversification across asset classes, says Derek Horstmeyer, an assistant finance professor at George Mason University.
Add an emerging markets index fund, a small-cap index fund or even a frontier markets fund if taking on more risk is not an issue, he says.
Expense Ratios Are Higher Than Some Index Funds
Target-date funds are actually a fund of funds, in which the portfolio manager selects a mix of mutual funds to target the appropriate risk for an investor's projected retirement date and funding needs, Michelson says.
One major disadvantage are the higher expenses -- the fund charges management fees and expenses for the target-date fund on top of the fees and expenses charged for the individual funds in the portfolio, he says.
The average fee for target-date funds dipped to a low of 0.62% in 2018, down from 0.66% in 2017, Morningstar reports.
The fees for target-date funds, many of which own index funds of benchmark indexes like the S&P 500, are still high compared with inexpensive index funds, which can be charge around 0.1% as a net expense in some instances.
[See: 10 Ways to Maximize Your Retirement Investments.]
Investors Should Review Their Portfolio Strategy
Investors can choose among two different approaches towards target date funds -- either invest almost completely in them, allowing the fund manager to rebalance the portfolio or take a more hands-on approach to their retirement portfolio, he says.
An investor who only invests part of their portfolio in these funds may want to invest in a target-date fund with an earlier or later target date to adjust the risk and return mix of the portfolio, Michelson says.
Another option is to reduce the target date fund to about 50% of a retirement portfolio to have more control over their investments and invest the remainder in a stock mix, he adds.
Some target-date funds use different groups of assets than others, says Jodie Gunzberg, chief investment strategist at Graystone Consulting, a Morgan Stanley business. In equities, some target-date funds are split across domestic, international and emerging sectors while others are diversified through large-, mid- and small-cap stocks and value and growth stocks. In fixed income, some strategies are more allocated to nominal bonds though others use inflation-linked bonds, she says.
The funds that are chosen by the portfolio managers do make a difference, Gunzberg says.
"Some target dates employ more index-like funds, whereas some use very active funds and some even change funds through the lifecycle," she says.
Opting to use a later-dated target fund for more equity exposure can be problematic because there are likely other allocation differences in different retirement years between bond categories and alternatives.
"If one picks a later dated retirement year for more equity, an unintended consequence is they may get more highly concentrated equities or maybe could get more alternatives like commodities," she says.
Target Funds May Miss a Bull Market
Investors have been drawn to these funds since these assets are often the default option in a 401(k) tax-advantaged account.
One warning to investors about these funds is the conservative allocation can mean missing an upside in a bull market, says Alex Chalekian, CEO of Lake Avenue Financial.
The strategy of target-date funds is to move from a more aggressive asset allocation model to a more conservative asset allocation model. While this works in some scenarios, it can be "dangerous in others," he says.
As a portfolio example, an investor who picked a fund with a 2010 target date missed the downside of the financial crisis, but at the same missed the upside of the 10-year bull market that followed, Chalekian says.
"Assuming this individual was 60 or 65 when they retired in 2010, their nest egg will likely be a lot smaller if they remained in the same target-date fund," he adds.
[See: 10 Long-Term Investing Strategies That Work.]
A better strategy is using an asset allocation fund over a target-date fund, he says.
"I can always change the allocation according to my time frame, retirement needs and risk tolerance," Chalekian says.
Another factor to be aware of is that if your projected retirement date changes, there is no guarantee that an investor will meet their investment goals, Michelson says.
While many investors are a fan of the "set it and forget it" mentality that comes with a target-date fund, there are some risks, says Rich Messina, senior vice president of investment product management for E-Trade Financial.
"You may dream to retire by 60, but as you approach that age, it might not be so realistic," he says. "This is where target-date funds can fall short. Not only may your retirement age change, but your risk tolerance is likely different than your neighbor. Since they're designed for the masses, they can be limiting and they're not really customized for individual needs."
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