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Investing For Your Future Monthly MessageFebruary 2012 Target-date mutual funds, frequently described as a “set it and forget it” approach to investing for retirement, have grown in popularity during the past decade. In January 2011, they contained about $300 billion in assets. Target-date funds are increasingly the “default option” for 401(k) retirement savings plans where workers are enrolled automatically unless they “opt out.” They are built on the long-standing assumption that investors should have less stock and more fixed-income securities in their portfolio as they get closer to retirement.
2006 federal pension legislation established qualified default investment alternatives as “safe harbors” for investing workers’ defined contribution plan assets. This prompted many employers to start using target- date funds, instead of money market funds, as the investment choice for workers who don’t select their own investments. Target-date funds are available through more than 40 investment companies for purchase individually or through an employer retirement savings plan (e.g., 401(k) plan). Some leading providers include American Century, Fidelity, T. Rowe Price, Schwab, and Vanguard.
Target-date funds hold a mix of stocks, bonds, and/or cash equivalent (short-term income) assets and gradually become more conservative (read: a smaller percentage of stock in the fund portfolio) and income-oriented as the “target date” (e.g., 2030) approaches and, once it is reached, going forward. For example, a target-date fund might start out with 80% of its portfolio invested in stock funds and gradually shift to 40% over the course of three decades without the need for any action on an investor’s part. Investors generally choose a fund target-date fund that coincides with their planned retirement date or a date beyond that if they want to invest more aggressively. The target dates in target-date funds are generally provided in five- or ten-year intervals (e.g., 2020, 2025, 2030, etc.).
Combining several asset classes in one mutual fund and having it gradually grow more conservative over time does not mean that target-date funds don’t have risks, however. This became painfully clear during the stock market meltdown of 2008. Typical 2010 target-date funds, held by those just about to retire, lost 25% of their value because they held about 45% of their portfolio in stock. One 2010 fund plunged 41% because the percentage of stock in its portfolio was higher. Stock and bond allocations vary among target- date fund providers. This makes it critical for investors to understand a specific fund’s “glide path” (i.e., planned changes in asset weightings over time as the fund approaches the target date and beyond).
Another thing that target-date fund investors need to carefully scrutinize is fees, which vary considerably among investment companies. A 2011 government report found that some target-date fund investors pay up to nine times what others do. Over time, this cost difference can amount to thousands of dollars in lost investment earnings. Most target-date funds are “funds of funds” that create their portfolios by investing in other mutual funds. With many of these funds, investors pay two sets of expenses: the expenses of the fund itself and those of its underlying funds. As with expenses for any type of mutual fund, the lower the expense ratio (fund expenses as a percentage of fund assets), the lower the cost to investors, which means they get to keep more of what they earn.
Information about a specific mutual fund’s expense ratio (a combination of management and operating expenses) can be found online and in its prospectus. Look for a target-date mutual fund expense ratio less than 0.75%. Some target-date funds sold by brokers charge yearly expenses of 2% or more. Funds with aggressive investment strategies, including those with more distant target dates, typically have higher expense ratios than more conservative funds because there is more stock to manage in their portfolio.
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