It’s a one-step strategy for investing for retirement: Put your money in a target-date fund and let the pros handle the rest. They’ll decide how much to invest in stocks, bonds and other categories; which funds to buy; and whether you need to beef up your exposure to emerging-markets stocks or shrink your government-bond holdings. And with every passing year, they’ll adjust the portfolio to make the holdings more conservative as you age. In some cases, the managers will even continue to fine-tune the portfolio after you retire. In other words, target-date funds aim to make investing simple.
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What looks simple, however, is anything but. TDFs may promise to tackle many of your investment decisions, but there are no guarantees that they’ll achieve their goals—or yours. These funds can lose money in any given year—as they did in 2008, a calamitous year for nearly all investing categories.
Performance among TDFs can vary dramatically, too. Fees, the underlying funds in the portfolios, and the changing mix of stocks and bonds throughout the fund’s life span all play a role in determining how well, or how poorly, a fund performs.
Compare the long-term results of T. Rowe Price Retirement 2030 (symbol TRRCX) and State Farm LifePath 2030 (NLHAX). Over the past ten years through June 30, the former returned 8.0% annualized, and the latter earned 5.5% a year. If you had invested $10,000 every year in the T. Rowe 2030 fund starting in 2003, your investment would be worth almost $160,000 today—$20,000 more than you would have in the State Farm 2030 fund. The bottom line: TDFs make retirement investing easier, but they don’t absolve you from determining whether a particular target-date series is a worthy investment.
Often, though, you may not have a choice. Retirement plans typically offer just one target-date series from a single firm, such as Fidelity or Vanguard, the two biggest players in the 401(k) world.
What if the funds in your 401(k) are duds? Even though you’re giving up the autopilot feature that target-date funds offer, says Morningstar analyst Josh Charlson, “you’re probably better off using a balanced fund, if one is offered in your plan, or to put together your own simple balanced portfolio based on low-cost options in the plan.”
An easy, do-it-yourself solution: index funds, which are offered in many retirement plans. If you have four decades to go before you retire, consider investing 90% in a stock index fund and 10% in a bond index fund. That’ll give you the same stock-bond breakdown as that of Vanguard’s 2055 fund. Just bear in mind that bond prices fall when interest rates rise, so your bond fund may deliver substandard results until rates stabilize. And it will be up to you to adjust the allocation to fit your comfort level as you age.
Knowing a TDF’s glide path is crucial to understanding the fund’s risk profile. The glide path refers to the shift in a TDF’s allotment to stocks, bonds, cash and other asset classes over time. The further a fund is from its target date, the greater the allocation to stocks; the closer to its target date, the lesser the stock allocation. The move toward fewer stocks is deliberate because stocks are generally riskier than bonds and cash.
But each target-date series takes a different path. For example, although the typical 2050 fund—designed for someone with more than 35 years to go before retirement—has 90% of its assets invested in stocks, some have as much as 100% in stocks, while one has as little as 60% (the outlier is Pimco, which uses a unique strategy).
The closer you are to retirement, the larger the disparities. For instance, current stock allocations in funds dated 2010 range from 20% to 60% of assets. A major reason for such discrepancies is the way fund sponsors view the purpose of their glide path. Some glide paths keep adjusting until a fund reaches the target year, then stop. Most sponsors, however, adjust their allocations through the target year and beyond, into retirement.
Some glide paths start out aggressive and remain so. Others start conservatively and end more aggressively than the typical fund. You should feel comfortable with the glide-path strategy of your target-date fund—from beginning to end. Read the fund’s prospectus, which will illustrate the life span of the path, to learn what happens to the allocation strategy as you near retirement and after you retire.
Know a fund's innards
A TDF is only as good as its underlying holdings, so you should familiarize yourself with them before you invest. In addition to getting to know the ingredients, you’ll learn how the target-date portfolio tilts toward more narrowly defined classes, such as foreign stocks, small-company stocks, real estate trusts and high-yield bonds.
Some TDFs, such as those offered by American Funds, hold only actively managed funds. Others, such as Wells Fargo, use only index funds. Still others, such as Schwab, hold both active and index funds. To add to the confusion, some firms offer multiple target-date products. TIAA-CREF has one index-based series and another series that uses only actively managed funds.
Index funds either do a good job of tracking the index they’re designed to mimic, or they don’t. In most cases, how well an index fund performs is determined by the fees it charges.
Assessing actively managed funds is trickier. Start by favoring funds that have been run by the same manager for at least five years and have beaten, or at least matched, their peers or an appropriate benchmark over that period. In addition, scan calendar-year returns going back to at least 2008. A TDF holding that has lagged its benchmark for more than three or four years is a cause for concern.
Beware high costs
The average annual expense ratio of the lowest-cost share classes of all target funds is 0.7%, says BrightScope, which rates and analyzes 401(k) plans. That includes the costs of the underlying funds as well as any additional TDF management fee (most TDFs layer management fees on top of fund expenses). Of course, you may not have access to the cheapest share class of your fund, but you can use the 0.7% figure to judge the costs of your target-date series. Depending on the share class, the expense ratio for Wells Fargo’s index-based target-date funds ranges from an average of 0.35% to a shockingly high 1.63% per year. For the two classes of Fidelity’s actively managed Freedom funds, the average annual expense ratios are 0.57% and 0.60%. Vanguard, the industry fee leader, charges an average of 0.17% annually. Fund prospectuses and your quarterly 401(k) statements include information about expense ratios. As always, the lower, the better.
Judging a TDF’s overall results can be especially challenging. A TDF’s ever-changing allocation and its broad mix of asset categories make it difficult to match the funds with appropriate indexes. Still, you can get a rough idea of a TDF’s relative performance by comparing your fund with TDFs with the same target year at Morningstar.com. But your best bet is to circle back to the criteria we’ve already discussed: Focus on fees, the strength of the underlying funds and the glide path you’re most comfortable with.