22 September 2021

Target-Date Funds: What You Need to Know

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For investors who want a “set it and forget it” retirement account, target-date funds have been the go-to solution.

An estimated 40 million Americans have put at least part of their retirement money in target-date funds since they first started hitting the market in the early ’90s. The amount of money in target-date mutual funds and exchange-traded funds—whose mix of stocks and bonds go from riskier to more conservative over time—has now reached $1.746 trillion. If you have a 401(k) or other retirement account that invests in the market, chances are that some of your money is in a target-date fund.

But many investors are in the dark about target-date funds—how they work, how much they cost, whether there are risks.

At the same time, some members of Congress have questioned whether these funds are worth it for investors. In May, members of the House Committee on Education and Labor as well as the Senate Committee on Health, Education, Labor and Pensions requested that the Government Accountability Office investigate target-date funds.

What is in these funds, and why are they being scrutinized? Here’s what you need to know.

How do the funds work? 

Typically, target-date funds include a mix of stock funds and bond funds. These can be either actively managed mutual funds or index funds (and there are also target funds in the form of collective investment trusts—low-cost investment vehicles that use strategies similar to mutual funds). The exact mix of stocks and bonds is partly based on an investor’s age when they enter the fund and partly on when the investor plans to retire. Target-date funds create what is called a “glide path” based on this information.

Generally speaking, the glide path is designed so that the portfolio is growth-oriented during an individual’s prime earning years and then shifts to a focus on capital preservation the closer someone gets to retirement—the “target” year. (That target year will usually be part of the fund’s name. A fund with 2022 in its name, for example, is geared for someone retiring next year.)

How much do they cost? 

Prices vary considerably depending on the provider and customizations. Vanguard Target Retirement 2050 Fund (VFIFX), which relies on Vanguard’s low-cost index funds, has an annual expense ratio of 0.15% of assets. At the other end, Fidelity Freedom 2050 Fund (FFFHX), which uses Fidelity’s active-management approach, has an expense ratio of 0.75%. The bulk of target-date funds land somewhere in between, with the average expense ratio being 0.55%, according to Morningstar.

Costs have come down within target-date funds as providers shift from mutual funds into lower-cost vehicles, including collective investment trusts and index funds. But it is still important to understand the total cost of the investment so that it doesn’t significantly erode your portfolio returns over time. If your 401(k) includes a custom target fund—which includes alternative asset classes such as real estate—the fees could be higher than a fund from a low-cost provider.

What kind of performance can I expect? 

It depends. Target-date-fund providers were investigated after the 2008-09 financial crisis because many of the funds posted significant losses owing to highly concentrated equities positions—even though fund providers touted the offerings as low risk. Since then, target-date-fund providers have taken steps to make sure that there is better risk management in place. The funds were tested last year during the pandemic, but they fared well. Funds that reached the end of their glide path in 2020 ended the year up 10.8% on average, according to data from Morningstar.

What happens when I retire? 

Target-date funds are designed to deliver you to your desired retirement age, but once you get there, what to do next is up to you.

Many investors are opting to leave assets in the target-date fund beyond the target age because it can be easier than trying to change. The assets generally stay in whatever mix of investments was in place when the fund reached the target date.

If you decide to roll over the fund from a 401(k) or IRA to a Roth IRA or an annuity—two of the most common choices—you may need to pay up. There are conversion costs associated with both options. Annuity conversion fees, for example, can range from 2% to 4% of the total value of the portfolio.

Depending on the type of IRA investors pick, they could have a significant tax bill at the point of conversion, based on a number of factors. A financial adviser can help with the decision.

Are there downsides? 

Yes—the cost.

Remember, target-date funds have high expense ratios. So, over the life of the fund, you’re eroding the size of your total portfolio faster than you would with a cheaper investment.

Then, when it comes time to sell, you’re likely going to get hit with even more costs. If you sell into an up market, you will face capital-gains tax, assuming you’re not in a tax-advantaged plan like a 401(k) or IRA. Plus, putting the money someplace else—such as a Roth IRA—will come with a price tag and probably additional taxes. The impact of all that could be relatively minor if you’ve saved enough; if you haven’t, it could be a major pain.

And, remember, all of that assumes you’re selling into an up market. A down market, combined with higher fund expenses, could amount to a bigger bite out of a portfolio than investors anticipate.

Why are these funds being scrutinized now? 

The Government Accountability Office has agreed to look into the funds and determine whether an update to guidance released in 2011 on how to choose the right target-date fund is appropriate. The GAO is investigating the variation among target-date funds in terms of the mix of stocks and bonds, fees and performance. Congress has questioned whether the variation makes it too difficult for average investors to compare funds and understand what they own.

Congress also specifically asked the GAO to focus on whether target-date funds are too heavily weighted toward equities near retirement, which could make them riskier than many investors anticipate.

Additionally, the GAO will be looking into a recent Labor Department rule change that would make it easier to include alternative investments like private equity in target-date funds, which could lead to higher fees.

Could new asset classes be added? 

Last summer, the Labor Department confirmed that plan sponsors could consider target-date funds that include private equity without running afoul of retirement rules designed to protect investors from risky and expensive investments. That opened a door for investment managers to begin including the asset class in retirement funds. However, to date there aren’t any providers that have opted to do that in their off-the-shelf target-date funds.

Congress has asked the GAO to look into the rule change as part of its investigation into target-date funds, given the higher investment fees associated with private equity. Adding private equity could also raise some issues around transparency, as private funds don’t have the same disclosure requirements as mutual funds or index funds. Providers that are interested in adding private equity to target-date funds will likely wait for the outcome of the GAO’s research before adding the asset class to funds.

GLOSSARY

Life-cycle funds: Another name for target-date funds. Life-cycle funds are not to be confused with lifestyle funds, which generally don’t change their asset allocations over time in a predetermined way. Target-date or life-cycle funds, in contrast, are designed for people expecting to retire in a particular year. That year is usually a part of the fund’s name.

Glide path: The asset-allocation path that the target-date fund follows to become more conservative over time, as retirement approaches.

Qualified default investment alternative (QDIA): An investment option in a retirement plan that an investor can be put into if he or she doesn’t choose otherwise. Target-date funds qualify, as do balanced funds and managed accounts.

Corrections & Amplifications

Life-cycle funds, also known as target-date funds, automatically adjust their asset mix over time—designed for people expecting to retire in a particular year. These funds are different from lifestyle funds, which generally don’t change their asset allocations over time in a predetermined way. The Glossary in an earlier version of this article incorrectly used the lifestyle-fund definition for the life-cycle funds. (Corrected on Sept. 8, 2021)

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