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My employer offers target date funds in our 401k. How do these funds work?

May 03, 2013 by Mike from Crofton, MD in  |  Flag
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A target date fund is an investment that has a set future date to which it tailors its asset allocation. It combines stocks, bonds and other investments into a single fund. For example, a 2030 target date fund will have an asset allocation that is heavy on stocks and light on bonds. This is an aggressive allocation which allows the investments to grow in the allotted time frame. As it nears the target date, the fund will begin changing to a more conservative allocation. This is to protect the assets from large fluctuations as it nears the date where holders will likely begin withdrawing money. Even if you plan to retire in a certain year, you may not want the target date fund for that year. Keeping with the 2030 retirement date, if you are a more conservative investor you might want to pick the 2025 fund. Or if you want to be more aggressive, pick the 2035 fund. It all depends on your risk tolerance. Hope this helps…

Comment   |  Flag   |  May 03, 2013 from Denver, CO

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They are pre-mixed funds usually consisting of other funds ("funds of funds"). Get the ticker symbol and check the expense ratios. Very often, they are expensive in terms of annual expense ratios because the fund company charges a fee for mixing the funds contained in the target date fund, so you have expenses for the wrapper on top of expenses for the contents. The theory behind the funds is that they will become less aggressive as the targeted date approaches. This theory is not necessarily correct when applied to any particular individual. Additionally, what does "getting more conservative" really mean in an economic context where interest rate risks for bond funds might increase in the future? Target date funds have become very popular in recent years, but I have to ask whether a particular investor really benefits. The fund companies who offer them must like them because of the increased fees they receive for them

Comment   |  Flag   |  May 03, 2013 from Raleigh, NC

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Brad Raines Level 15

Mike - Walter is exactly right in that these target date funds are simply a bucket of other mutual funds covering most of the main asset classes (large company stocks, international stocks, corporate bonds, treasuries, ...etc.). The cost to build and manage these buckets is what leads to the higher expenses. So if your goal is strictly low expenses then you are probably best served to build your own bucket using the individual mutual funds in your 401k lineup. But, these target date funds can be useful if you believe that your investment allocation is more of a priority. I find that many 401k investors can be distracted by the slightly higher fees of the target date funds, but then take way too much risk by overweighting (ie all international stocks) in some areas or by "chasing returns" where you're constantly moving your money to the funds that are hot (after they've done well). Unless you are willing to spend ample time keeping up with your 401k allocation while holding yourself accountable, then the target date funds might be a good option for less maintenance and balanced exposure to all the available assets classes. Good luck!

Investing with purpose. www.appliedcapital.com

Comment   |  Flag   |  May 03, 2013 from Little Rock, AR

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Mike,

Target Date Funds are turnkey Fund of Funds that use a pre-defined asset allocation mix between stocks and bonds and rebalance automatically as one gets closer to retirement. So for example, if you are a young investor starting to invest in a retirement plan, 80% of your money should go to equities with balance 20% to fixed income. As you head towards retirement, theoretically, you should be moving more and more of your assets into fixed income, so that when you are in retirement, you have 80% invested in fixed income and 20% in equities.

These funds are supposed to do all the work for you, as you do not have to calculate your asset allocation mix nor re-balance your portfolio periodically. It is designed to BUY and FORGET and simply dollar cost average over your lifetime.

Now the larger question is have they served their purpose and are they a good and viable option today. By and large they have served their purpose as they have lowered the costs and reduced the complexity for most plan investors. However, the question is, are the traditional asset allocation paradigms still valid, given that a 40 plus year bull market in traditional fixed income is almost coming to an end. In fact, there was an interesting article in the Wall Street Journal today talking about 'Target' Funds Vulnerable to Rate Rise. The link to this article is posted below:

http://online.wsj.com/article/SB10001424127887324763404578432791652311774.html?KEYWORDS=401%28K%29+Plans

If you have further questions on a specific target date fund or family of funds, feel free to call or email me and I will be more than happy to do some research for you. You can find our contact information on our website at www.endowmentwm.com.

Comment   |  Flag   |  May 03, 2013 from Appleton, WI

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Mike - the target date funds are supposed to make it easy for 401K investors. They work by asking one question - what year you will retire. From that information, the "target date" is set. The fund invests the money with a balanced approach dividing the investment allocation into stocks, bonds and cash. If the target date is further away, more of the fund percentage would be in stocks. Then as the years get closer to retirement, the fund adds more and more to the bond allocation and reduces the stock allocation. However, I would be cautious using this funds. This reason being that although you will retire at a certain target date, you will likely have a longer retirement than these targets assume. Thus, you may need a substantial percentage in stocks as you approach retirement - and even in retirement - to allow for the potential to get lifestyle sustaining investment returns for what could be a 3+ decade retirement. Good luck and save the maximum in your 401K, if possible.

Comment   |  Flag   |  May 03, 2013 from Allendale, NJ

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Rich Winer Level 20

Mike, If your plan offers "lifestyle" funds of funds (essentially a conservative, moderate or aggressive mix of various funds), that would be my preference because you always know what you asset allocation mix will be and that it's suited to your comfort level and return objectives. Both lifestyle and target allocation funds are intended to simplify the asset allocation and investment process for less-experienced investors. Any additional fees should be of less concern because these funds will hopefully increase the likelihood that your allocation will be appropriate and that you won't make costly investment mistakes buying and selling funds at the wrong times for the wrong reasons. My concern with target allocation funds is that while it make sense intellectually to have a more aggressive portfolio when you're further away from retirement, emotionally, you may not be comfortable with the allocation. Big bear market losses have scared many an investor out of the stock market and derailed their systematic plan for retirement savings. I think it's better to be comfortable in an allocation suited to your risk tolerance that also meets your investment objectives. Hope this helps.

1 Comment   |  Flag   |  May 03, 2013 from Woodland Hills, CA
Walter L. Sheffield III, JD, CFP®

I agree that "target "risk" or "lifestyle funds," while sharing the cost considerations of target date funds, can be an effective way to stay invested and avoid chasing returns. Risk tolerance can be re-evaluated from time to time on a personal basis as life events approach, without trying to time the markets.

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Flag |  May 03, 2013 near Raleigh, NC

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Mike, a Target Date Fund sets your retirement ‘target date’ as the date you plan to retire. As you get closer to the ‘target date’ the fund assumes you need these assets to be safer, and shifts the allocation to lees stocks and more bonds and cash. It is not unsuitable for anyone, and so it is used.

My position is that not everyone who plans to retire this year wants to be in bonds and cash. Conversely, not everyone in their 20’s wants to be primarily in stocks. I would prefer to see you take an asset allocation risk questionnaire, and select the risk allocation where you feel comfortable. Your plan should also offer Asset Allocation models, ie: Conservative, Moderate, Growth, asset allocation models. You will get a balanced, well diversified mix of investments that you can sleep with.

Keep in mind the expense ratios on both of these managed portfolios will likely be higher than if you select individual funds. But if you have little or no investment experience, it may be well worth it.

Comment   |  Flag   |  May 07, 2013 from Delray Beach, FL

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