A target-date fund is a hybrid mutual fund that automatically resets the asset mix of stocks, bonds and cash equivalents in its portfolio according to a selected time frame that is appropriate for a particular investor. A target-date fund is similar to a life-cycle fund except that a target-date fund is structured to address some date in the future, such as retirement. Its returns are not guaranteed but, instead, depend on how the market performs.
Target-date funds are composed of several funds representing different investment styles or asset classes. Target-date funds are popular with 401(k) plan investors. Instead of having to choose a number of investments to create a portfolio that will help them reach their retirement goals, investors simply choose a single fund designed to help them reach that goal. The fund’s managers then rebalance the fund’s assets each year and keep its investments on track to meet the fund holders’ goal of using that investment to begin paying for their retirement in a particular year.
While target-date funds have an air of simplicity, they are often misunderstood by investors. A 2012 study by ING showed gaps in investor understanding of how target date funds are designed, how they are managed, and what they are designed to do.
An example of the confusion concerns controlling risk. More than 70% of all respondents (79% of target date fund users and 71% of non-users) said they wanted stronger protection from investment losses. Yet only about half (55%) knew a target date fund’s allocation was designed to become more conservative over time. Worse yet, just 44% thought the allocation would be automatically changed over time. And just 53% were confident they would reach their retirement goals. (Among respondents who did not use target date funds, the percentages were even lower.)
The confusion extends to portfolio allocation. Both target date fund users and non-users thought diversification is important, with more than 80% of all respondents indicating an interest or strong interest in diversification. However, less than two-thirds (63%) of target date fund users believed their funds held a diversified mix of stocks and bonds. This may partially explain why 47% of target date fund users thought they needed to own other funds to obtain more diversification.
A target date fund can play a role in a portfolio if an investor understands the fund’s investing and allocation strategy. Specifically, investors need to read the prospectus to learn how the allocation changes over time and what happens after the target date is reached. It is also very important to find out if the allocation will continue to evolve after the target date and at what point the fund will be liquidated or folded into another fund.
To learn more about target-date funds, be sure to check out these AAII articles:
Weekly Survey Question
To see how popular target-date funds are with our readers, we posed this question to them last week:
What percentage of your overall investment portfolio is invested in target date funds?
Here are the results:
The overwhelming number of respondents–87% of the 2,161 who voted as of 6 a.m. (Central) on Sunday–said they do not invest in target-date funds. This is probably not surprising, given our typical reader. AAII members, on average, tend to be near retirement age or are already retired and are more hands-on with their investments. Target-date funds, however, are optimal for someone with a longer investment time horizon and are attracted to the “set it and forget” feature aspect of target-date funds.
Among the 13% of readers who said they do invest in target-date funds, 61% have less than 10% of their overall investment portfolio invested in target-date funds. Nearly 9% of those invested in target-date funds have more than 50% of their portfolio devoted to these investments.
Special Question Summary
To get a sense for what attracts and repels investors to and from target-date funds, last week’s special question asked:
What do you consider to be the biggest advantages and drawbacks of investing in target date funds?
In all, 165 respondents offered their thoughts on the pros and cons of using target-date funds. We compiled all of the responses, and in all, there were 220 separate comments. From a high-level perspective, these comments broke down 60% to 40% negative versus positive.
Looking at the comments in favor of target-date funds, nearly 38% said the “simplicity” of target-date funds was a key advantage, with the phrase “set is and forget it” mentioned multiple times. Another 23% said the automatic shifting of asset allocation over time, instead of having to make the adjustments yourself, was a reason target-date funds are an attractive investment option. Several respondents referred to an automatic pilot of the investing glide path.
Looking at the responses that cast target-date funds in a negative light, 45.4% said they were too conservative in their asset allocation–namely overinvested in bonds–or that they preferred to invest themselves and did not like the loss of control. Another 14.1% pointed to the relatively poor performance of target-date funds as a deterrent while 12.1% said the higher fees associated with many target-date funds being “funds of funds” was a turnoff.
Here is a sampling of the responses:
- “[Target-date funds] are better than sitting in cash.”
- “A desired Risk/Reward ratio of a group of stocks and bonds can be selected without much effort.”
- “Another advantage is that [target-date funds] include bond purchases that are bought at institutional prices.”
- “Set it and forget it.”
- “Prevents whimsical rebalancing.”
- “Advantage: autopilot. Disadvantage: autopilot.”
- “Advantage is not having to watch, worry or concentrate on investments.”
- “They nudge younger investors into greater equity exposure, which is generally agreed to be appropriate.”
- “Disadvantage: Less knowledge as to what the [target-date fund] will be holding.”
- “The lack of control or knowledge of where money is invested could be viewed as a drawback…”
- “You can make the same allocation decisions without incurring the fees associated with the target-date funds.”
- “I think these funds become overly conservative at about age 50 (assuming a 65 or 66 target date).”
- “Disadvantage: fees on top of fees. They are a rip-off.”
- “[One disadvantage is] having to switch from growth to income at a specific point that might be in the middle of a crash…”
- “The biggest drawback is that when you sell during a stock downturn you are taking a permanent loss on the stock portion of the portfolio. If you separate stocks and bonds, you can sell bonds during the stock downturn, and wait till stocks have risen in value again before selling.”
And the winner for best use of a metaphor:
- “Buying a target-date fund is like buying a tube sock. But feet are different. I know I am.”
Everybody has an opinion! Why not give us yours? Participate in our weekly member poll, updated every Monday, and see the results online at http://www.aaii.com/memberquestion.