Target date funds offer the premise of a one-stop solution for investors seeking professional allocation strategies.
They are commonplace in 401(k) and other similar employer-sponsored retirement plans (aka, defined-contribution plans). According to Vanguard, 88% of defined-contribution plan sponsors offer target date funds. Furthermore, four in 10 participants in a defined-contribution plan using Vanguard funds solely owned a target date fund in their workplace retirement account at the end of 2014 (“How America Saves 2015”).
The simplicity of target date funds’ premise is one reason why. A second significant factor is that these funds are default options in many workplace retirement plans. Many employers use target-date funds as the default investment alternative for new defined-contribution plan enrollees. Similar to auto-enrollment (employees are automatically enrolled in the retirement plan, often with a starting default contribution rate equal to 3% of an employee’s gross salary) and auto-escalation (the contribution rate is automatically increased each year and/or at the time a raise is given), employees have the ability to choose a different option. Many don’t.
Despite this growth, there remains confusion about how to use target date funds. Financial Engines found that 62% of investors who only partially allocate to target date funds do so to “avoid ‘putting all their eggs in one basket,’” even though most understood that target date funds were diversified investments (“Not So Simple: Why Target-Date Funds Are Widely Misused by Retirement Investors,” March 2016). A survey by Voya Investment Management revealed similar behavior, with 46% of target date fund users listing diversification as a reason they use other investment options in addition to target date funds (“Participant Preferences in Target Date Funds: Fresh Insights,” January 2016).
Given this backdrop, it seemed warranted to revisit target date funds and provide an update to the October 2012 article, “Target Date Funds: A Simple Premise, but Underlying Complexities.” In doing, some changes came to light.
Continuing reading this article for information on:
- How target date funds work
- Allocation strategies used by target date funds
- How these allocation strategies change over time and the impact for investors
- How investors can go about selecting target date funds