If your employer has a 401(k) retirement plan, it probably offers a series of target-date funds, or TDFs. In fact, your account may be invested in a TDF, whether you selected it or not.
A TDF is a type of mutual fund. A traditional mutual fund usually represents a single asset class (like large-capitalization U.S. stocks) and is a portfolio of individual securities. A TDF, by contrast, represents multiple asset classes (both stocks and bonds) and is generally a basket of underlying traditional mutual funds.
TDFs have a year as part of their name, corresponding to the year the employee expects to retire. Fidelity, T. Rowe Price and Vanguard are the largest providers of TDFs, accounting for about 73 percent of assets. Each offers a series of TDFs, spaced at five-year intervals. For example, Vanguard Target Retirement 2025 is designed for employees who expect to retire in 10 years, while Vanguard Target Retirement 2045 is designed for those expecting to retire in 30 years.
The basic premise of a TDF is the allocation to the underlying asset classes is managed to reduce risk as the target date approaches. While stocks have generally higher returns (vs. bonds) over long periods, the short-term variability of returns is also much higher. Thus, Vanguard 2025 holds about 70 percent of its assets in stocks, while Vanguard 2045 holds almost 90 percent.
The rate at which a TDF adjusts its allocations to stocks and bonds over time is referred to as its glide path and can vary between the various providers of TDFs.
TDFs have exploded in popularity. Morningstar estimated that at the end of 2013 more than $600 billion was invested in TDFs, more than double the amount invested just four years earlier. Cerulli Associates predicts in four more years TDFs will attract 63.4 percent of 401(k) contributions and account for 35 percent of total 401(k) assets.
This growth can be attributed to the Pension Protection Act of 2006, which allowed employers to automatically enroll eligible employees in their 401(k) plans and direct contributions to a “qualified default investment alternative,” which includes TDFs.
For employees, TDFs offer professional advice on asset allocation that is implemented automatically. Investing in a TDF allows you to focus on the most important variable (and one of the few you can control)—how much you save. Note that if your employer offers to match part of your contribution, this is “free money” and you should try to contribute at least up to the maximum match level.
TDFs offer a seemingly simple solution to a bewilderingly complex task, but investing in a TDF in no way guarantees you will have enough money to retire.
In addition, the tremendous popularity of TDFs has attracted a bevy of providers fighting for market share, many trying to differentiate themselves by using unconventional strategies. This has led to wildly different performance for funds with the same target date. The Wall Street Journal recently listed the best and worst performers for various target dates for the 12 months ended April 30, 2014. For example, American Funds 2025 Target Date Retirement returned 14.9 percent, while Pimco RealRetirement 2025 returned only 1.4 percent.
All TDFs operate under the same basic premise, but employees need to understand there are important differences.•
Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or firstname.lastname@example.org.