When my daughter sought my advice on choosing an investment for her retirement plan at work, I suggested a target-date fund, or TDF. My thinking: It was a logical selection for a young investor with little interest in assembling and monitoring a portfolio on her own.
Allison, who’s in her mid-20s, chose a 2060 fund. This date most closely matches the year she expects to retire—the point at which one stops working and earning income and begins relying on Social Security, pension, 401(k) plan, IRA, or other assets.
Most target-date series offer funds in 5-year increments. If you’re a prospective investor in a TDF for an IRA, it’s a bit more complicated than simply picking the date closest to your retirement year. Here are 6 tips on choosing one that will best meet your needs.
Step #1: Gauge glide paths
When researching TDFs, you’ll inevitably encounter the term “glide path.” A glide path is the predetermined rate at which a fund changes its asset allocation over time. Typically, target-date funds start off with a large percentage in stocks and gradually decrease that amount in favor of a greater weighting in bonds as the stated target date approaches.
It’s important to note that glide paths can vary widely from one TDF series to another. Visit the sponsor’s website or refer to the prospectus to understand how its asset allocation will change over the life of the fund, especially when you’re near and in retirement.
Step #2: Assess asset classes
Next, “look under the hood” and determine what investments the fund holds. Some funds stick primarily to the major asset classes, such as stocks of U.S. and developed international markets, as well as U.S. and international government and corporate bonds. Others mix in stocks and bonds from emerging markets, “junk” bonds, real estate, inflation-protected securities, and commodities.
Step #3: Investigate the investment approach
The primary question here is index vs. actively managed? Some TDFs comprise actively managed funds, which seek to outperform similar funds or a market benchmark. To do so, managers use research, market forecasts, and their own judgment and experience to buy and sell securities. Other TDFs are composed of index funds. An index is a group of securities that represents a market or a portion of a market. An index fund seeks to track the returns of a market, such as the broad U.S. stock market, or market segment, such as short-term bonds.
Over time, indexing has performed favorably relative to active strategies, largely as a result of lower costs. Some active managers have outperformed peers and benchmarks over various time periods, but evidence suggests that the likelihood of outperforming with consistency is extremely difficult over time because of the higher costs associated with active management.
Note, too, that many TDFs adhere to a static asset allocation strategy, which means the underlying portfolio remains the same (except for the glide-path changes). Some funds, however, are more tactical, changing the portfolio as market conditions change.
Step #4: Recognize the risk-reward trade-off
Depending on the factors outlined above, a TDF is subject to varying types and levels of risk. In my mind, it largely comes down to a trade-off between market risk (i.e., the fluctuations in price due to movements in the financial markets) and shortfall risk (i.e., the possibility that a portfolio’s value is less than expected and insufficient to meet an investor’s needs.)
While stocks provide the best opportunity for growing capital and protecting against shortfall risk, these securities also expose you to a high level of market risk. At the same time, shortfall risk may be exacerbated by high inflation and increasing health care costs.
Balancing market risk and shortfall risk is especially important for retirees. Make sure you’re comfortable with the level of market risk, with equal consideration to the length of your retirement, your health, and other income sources, such as a pension and Social Security. Your retirement may span 20–30 years, so some stock exposure is important for growth.
Step #5: Put performance in perspective
You may be tempted to pick the top-performing target-date fund and call it a day, but I recommend taking a closer look at its track record before investing. First, compare a fund’s performance to its peers over 5- and 10-year periods (or longer). Generally a fund with a higher stock allocation is likely to provide a higher return, accompanied, of course, by greater short-term volatility.
Second, take a look at performance in each calendar year.
Third, for good measure, check performance in a down market. The first quarter of 2020 will give you a good idea of how the fund weathers market volatility.
Step #6: Consider cost
Costs matter, especially over time. Specifically, compare expense ratios, which are the funds’ annual operating expenses expressed as a percentage of average net assets.
You don’t get a bill for these operating costs because they’re paid directly out of a fund’s returns. That’s why it’s important to know what you’re paying. Over the life of your investment in a TDF, which is likely to be 40 to 60 years, lower costs can give you a better chance of reaching your goals and living a financially comfortable retirement.
Target-date funds simplify the decision-making process for investors and provide ready-made portfolios suitable for retirement planning. If, for whatever reason, you don’t want to put together a well-balanced, diversified investment program on your own, a TDF should be one of your considerations. If you have more complex financial needs, you may want to consider financial advice. I’ll explore this option in my next blog post.
- Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.
- These fund suggestions are based on an estimated retirement age of approximately 65. Should you choose to retire significantly earlier or later, you may want to consider a fund with an asset allocation more appropriate to your particular situation.
- All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Investments in bonds are subject to interest rate, credit, and inflation risk.