A Guide to Target Date Funds, Part I: History
Target date retirement funds have seen exponential growth over the past ten years, and are the source of great consternation for both regulators and people investing for retirement. This post will briefly describe target date funds, list their pros and cons, and make a few suggestions for using them.
First, a description. Any time we’re investing, there is a wide universe of securities from which to choose. Different types of securities tend to exhibit different characteristics. For instance, stocks tend to have more return potential, but also more risk, than bonds. When building an investment portfolio, theory and logic tell us that we should invest more heavily in securities with greater risk and return profiles when we have a long time until we need to access the funds. As we approach the target date (normally retirement date), the portfolio should gradually shift towards securities with lower risk and return characteristics, i.e. bonds. In other words, a 25 year old starting to contribute to their 401(k) should have at least 90% of their portfolio in stocks, as they have 40 years until they'll need to draw from the portfolio. If the stock market falls by 20% tomorrow, a 25 year old can stomach the drop given their time horizon. On the other hand, someone two years from retirement should be heavily weighted in bonds, as a stock market correction would be far more crippling. The stock/bond asset mix in between the two points should change gradually over time, and is called a “glide path.”
A target date fund is a mutual fund designed to provide a simple investment solution, and automatically adjust asset allocation as it travels along this glide path. Typically a group of target date funds will have several target dates from which to choose, with the target date being when you expect to begin withdrawing from the portfolio. For example our 25 year old would probably opt for a 2054 target date fund, because this is the year he’ll turn 65 and might want to retire. This fund would be heavily invested in stocks, but recalibrate each year to incorporate more bonds and lower portfolio risk as it approaches the target date. If the fund were invested today in 90% stocks and 10% bonds, it might be invested in 80% and 20% bonds in five years, and gradually slide to 30% stocks and 70% bonds by 2050. A potential glide path is shown below. In practice target date funds are mostly offered in five year increments, so the closest available would likely be a 2055 fund. Our near-retiree would probably shoot for a 2015 fund, or another offering "stable value" characteristics.
Target date funds were first introduced in the early 1990s by Barclays Global Investors, but were widely ignored until the Pension Protection Act of 2006. The act mandated (among other things) that 401(k) plans improve their default investment options. A default investment option relates to someone who contributes to their 401(k) plan, but doesn't elect which investment their contribution should go into. Prior to the act, most plans used very low risk, very low return money market mutual funds as default options. Realizing that such funds put apathetic investors at risk of falling short of their retirement savings goals (due to the low returns), congress decided to force 401(k) plans to provide a better option. Target date funds quickly gained popularity as default investment options as 401(k) plans scrambled to remain compliant. They have grown exponentially since then. Assets under management in target date funds were just over $100bn at the end of 2006, and grew to over $600bn by the end of 2013.
For more information, please find "A Guide to Target Date Funds, Part II".