Target Date Funds can be a simple, convenient “all-in-one” option for retirement investing. But choosing one requires some thought and care, and the fund should be monitored on an ongoing basis to make sure it continues to meet your needs.
Choosing a Target Date Fund
Depending on the particular target date, Morningstar lists offerings from on the order of 30 to 40 vendors. These differ in terms of:
- How you buy and pay for them
- Ongoing expenses
- Management approach (active versus passive)
- Asset Allocation (the portion of the portfolio devoted to equities, fixed income, cash, alternative assets, etc.)
- Glide path (How the asset allocation changes as you get closer to retirement)
Some target date funds are sold through financial advisors or brokers. You may pay an initial commission of 3 to 5 percent and/or an ongoing advisor management fee of 0.5 percent to 1 percent per year for these. Others are no-load funds that you research and purchase yourself directly through mutual fund companies or discount brokers. You save on the broker/advisor costs but you have to do the research yourself.
Target date mutual funds have an underlying expense ratio, which is essentially the percentage a fund charges to manage and administer the fund. The expense ratio can also sometimes include ongoing marketing charges depending on the fee structure for the fund. A review of the Morningstar database for a typical target date fund for 2030 shows prospectus net expense ratios that vary from 0.1 percent to 1.92 percent. Given that long-term fund returns might be in the 3 to 8 percent range depending on target date, a nearly 2 percent difference in expense ratio can represent a significant portion of the total return potential.
Returns themselves also vary. Of the target date 2030 funds in Morningstar that had a 5 year annualized return, the returns ranged from 0.39 to 7.25 percent. These returns were moderately negatively correlated with the ongoing expenses above. This means that in general, having a fund with higher expenses produced lower returns.
Returns can also be related to the asset allocation chosen for a particular target date. If the investment markets have been rising in general for example, one fund with a given target date may outperform another with the same date simply because the asset allocation was more aggressive, not because the managers made superior decisions. Also, if market conditions turn down, that same fund that outperformed may underperform in the future.
Because of these factors it is important to not look at return data for any given period in isolation. It needs to be considered in light of the factors that affect the returns.
Management Approach and Asset Allocation
Many target date funds are passive funds designed to track key investment indexes, but some are actively managed. Whether it is actively or passively managed will not be apparent simply from the fund name. You will need to dig into the prospectus or other related materials to determine this, so that you can pick one that is consistent with your own views about management approach.
Target Date Funds vary in terms of how much of the portfolio is allocated to equities for a given target date. Based on the Morningstar mutual funds database, the total combined allocation to equities for target date 2030 funds ranged from about 80 percent to just under 50 percent. The relative amount devoted to domestic versus international equities also varied. The portion of the equity allocation devoted to international stocks was typically in the range of 25 to 40 percent.
Further distinctions in asset allocation include:
- The proportion between large, medium, and small size companies
- The relative proportions of types of bonds in the fixed income allocation (corporate, government, treasury, mortgage securities, etc.) as well as whether or not there is an allocation to international bonds
- Use of alternative asset classes such as real estate, commodities, currencies, etc.
What is “under the hood” in terms of the actual asset allocation and types of investments in the fund can affect how it behaves under various market conditions, so it is important to have at least a rudimentary understanding of this when picking a fund. If a fund does not have all the asset classes in the proportions you would like, you may need to supplement the target date fund with other more specialized funds to round out the asset allocation.
The glide paths of target date funds can also differ. The graph below shows the most aggressive (in terms of total equity allocation) and least aggressive glide paths for target date 2010, 2020, 2030, 2040 and 2050 target date funds from the Morningstar database:
The graph shows that for retirement dates far into the future, there is relatively less variation in asset allocation among funds. Most are in the 80 to 90 percent range in equities. As the retirement date approaches, the variation in fund aggressiveness increases significantly because of philosophical differences among fund managers. The most conservative funds take a primarily “capital preservation” view of the fund objective once someone approaches or enters retirement. The ones with a higher proportion devoted to equities as the retirement date approaches take the view that the retiree may live another 20 or 25 years in retirement, and therefore continue to have need for potential growth in the retirement portfolio.
The Initial Choice
With all the factors and complexities that make up target date funds, how to choose one without “Paralysis through Analysis”? The two major considerations are:
- Making sure the asset allocation and glide path for your fund are consistent with your needs and objectives. The asset allocation affects the overall returns, but more importantly the variability of returns with market conditions.
- Understanding the costs, both initially and ongoing. This does not mean simply to buy the fund with the lowest expense ratio. Expenses need to be considered in the context of the return, management approaches, and other factors that may be important to you.
Target Date Funds in IRAs Versus Retirement Plans
If you have a target date fund in an employer retirement plan instead of an IRA, the decision is simplified somewhat because the plan sponsor has already picked the target date fund family. In such a case, your decision hinges more on picking the target date with the asset allocation that reflects your particular needs and objectives.
Monitoring a Target Date Fund
Even in a given fund family, the glide path for the different target dates can change over time in response to consumer demand, manager philosophy and other factors. After the 2008 to 2009 market crash many fund managers reduced the allocation devoted to equities for funds less than 10 to 15 years from their target retirement date. This was in response to consumer concerns about capital losses funds experienced just as they were entering retirement. More recently the trend has been to slightly increase the overall aggressiveness of the funds for many target dates, partly in response to competitive pressures related to investment returns.
So the most important consideration in monitoring a target date fund once you have picked it is to make sure that the asset allocation at any given time is consistent with what you want. Some funds may change their asset allocation when they reach an even five year milestone, such as 2015, 2020, etc. Others may make smaller changes more frequently. Checking once per year, or if you are notified of a strategic change in glide path by the fund company, should be sufficient.
If you no longer like the asset allocation of your fund, but you still like the fund family, you can simply switch to a fund in the same family with a target date that has an asset allocation more to your liking. Just because you are retiring in 2025 doesn’t mean you have to pick the 2025 target date fund. You could pick the 2030 fund if you wanted a more aggressive allocation or the 2020 fund if you wanted to be less aggressive.
Finally, although it happens less frequently than asset allocation and glide path changes, major changes to the fund managers can indicate a change in strategy or administration at the fund company. If such a change occurs you should review it to make sure the fund is still consistent with your objectives. If not, it may mean you need to start the evaluation process again from scratch and potentially pick a new fund.
*This article was originally published on Wealthminder.com.