Let's first examine what a TDF really is. It is nothing more than a mutual fund, usually made up of various other funds, that each specialize in something different. The key to a TDF is that it is suppose to become increasingly conservative in its investment allocation, as the targeted date approaches. TDFs are normally broken up by five-year increments (i.e., retirement date 2025, 2030, 2035). A 2040 TDF, for example, would represent a fund built for someone wanting to retire in the year 2040. As we get closer to that year, the fund should get more and more conservative to protect the investor from large market fluctuations as the client nears retirement. At least that is the theory.
There are pros and cons to these funds, so we will hit some of the main points below.
Target-Date Fund Advantages
- Easy - set it and forget it investment tool. An investment manager or management team will select a mixture of other funds that should be shifted automatically from aggressive to more conservative, as you near retirement.
- Diversity - provides a fair amount of investment and asset allocation diversity with one fund pick. That being said, each TDF has their own idea of diversity and allocation, so look at their holdings to make sure their ideals line up with yours.
- Fees - in exchange for making these allocations on your behalf, an additional fee will be levied on you. These additional fees average roughly 0.75%, according to a recent Brightscope TDF survey. This could cost well over $100K in additional fees over a 30-year career of saving for retirement.
- Allocation risk - exist because there are no set standards for TDFs. Fluctuations in allocation (which directly affect how volatile the fund can be) percentages can vary wildly from one fund to another. This means, for example, that all 2045 Target-Date Funds are not built equally. Each managing team can determine their own strategy. Some may be 40% equity and 60% fixed income, while others of the same target-date year will have the exact opposite allocation. This can definitely affect the volatility of your nest egg and how much sleep you get at night.
- Conflicts of interest - are easy to see here. Because of the ease of getting money into TDFs, fund families can easily add assets to less popular funds in the fund they want to grow by including them in a TDF. In addition, fund families might be swayed to hold larger equity positions (stocks, which can be volatile) than most investors would be comfortable with, as equity funds can typically charge higher fees than most fixed income funds do.
- Suitability standard - allows TDFs to operate in a manner less stringent than fiduciary care. In other words, the client's interests do not have to come first...by law. The fund management just needs to show the investments are "suitable" for the average person.
The Bottom Line
The key ingredient to building your portfolio for retirement is that you save, save, save! After that, having a good management plan can help you get all the mileage possible out of those funds, but the plan comes second to making sure you set aside funds to make it possible. Invest well!