Guide to target-date retirement funds

Introduction to target-date retirement funds

As 401(k)s and other self-directed investment and retirement savings accounts have gained popularity, so have target-date retirement funds. Target-date retirement funds may be considered a viable option for investors who do not want to actively manage their portfolios, while still having their investments rebalanced and adjusted according to their retirement time horizon. The general idea is that the investments held within the fund are primarily growth-focused early on and become more conservative as the investor reaches retirement age.

This is accomplished by utilizing an asset allocation that is heavily weighted toward equities early in an investor's working life. Over time, the portfolio gradually shifts toward less volatile investments, such as bonds and other fixed-income instruments, as the investor approaches retirement age. Target-date funds adopt this approach because younger investors typically have a longer time horizon, allowing them to recover from periods of volatility and depressed markets. Their primary goal is capital appreciation and the pursuit of higher returns, which equities tend to provide over extended periods. In contrast, individuals nearing retirement age generally aim to minimize short-term risk and safeguard their capital from significant market downturns as they transition into retirement.

Typically, target-date funds are named according to the year in which the investor expects to retire – for example, “Target Retirement 2050.” It is important to check whether a fund uses a “to retirement” or “through retirement” approach. “Through retirement” funds will continue to shift their allocation toward less-risky investments through your retirement date, not reaching their most conservative allocation until years into your retirement.

Benefits of target-date funds

There are a number of benefits to target-date funds, notably that they provide investors with a simple way to automatically tailor their investments toward their retirement time horizon. By making one investment choice, the investor is often instantly placed in a managed portfolio that is rebalanced and adjusted as the years go by and their retirement date nears. For individuals who are too busy, not interested in or otherwise unable to conduct the research necessary to construct a retirement portfolio, this can be a simple solution to such an important aspect of their financial lives.

As previously mentioned, target-date funds are designed to provide capital appreciation and growth through equity exposure early in an investor’s life, while providing capital protection and income in later years. For this reason, the fund’s returns typically start higher and gradually decrease as bond holdings increase. From 2018 to 2021, target-date funds that had between 33% and 43% equity exposure returned 7.7% annually, while funds with 25% to 30% equity exposure returned 6.3% annually.

How to select a target-date fund

Not all target-date funds are created equal, and it is important to compare multiple options before making a decision on which is best for you. It may also be helpful to consult a financial advisor during this process.

In order to compare different funds, you must understand the fund’s investments and how they will change over time. Each fund has a different philosophy on what mix of stocks and bonds is appropriate at any given point in an investor’s retirement journey, and it is important to make sure that your philosophy aligns with the fund’s. A fund’s investment strategy or “glide path” outlines what this process will look like. Some funds may have a “to retirement” glide path, while others may follow a “through retirement” plan. It is crucial to understand when the fund will reach its highest concentration of bond investments, also known as its most conservative phase.

You should also find out if the fund is actively or passively managed. An actively managed fund may adjust their glide path to try and capitalize on changing market conditions, while passive funds will typically stick with their path regardless of what is going on in the market. A fund’s prospectus is a good place to obtain this information.

Another important aspect that will affect your overall return is a fund’s fees and expenses. Fees, expenses and sales loads can vary widely from fund to fund. Understanding what they are, how and when they are charged, and what for will help you to determine which fund makes the most sense for you.

The bottom line

Target-date funds may offer a viable option for those who want to save and invest for retirement but do not feel comfortable making investment decisions. They are a way for investors to ensure that their portfolio is being adjusted according to their anticipated retirement date, and that their risk exposure is being lowered as they near that date to help ensure a successful retirement.

Aside from their simplicity, target-date funds have historically provided returns that are generally in line with market averages. At or near retirement, the funds shift from a capital appreciation to income generating asset allocation, helping to provide investors with the cash flow needed to fund their retirement lifestyles.

It is important for investors to get all the facts and compare a number of funds before deciding which fund is right for their needs, goals and risk tolerance. A financial advisor can help during this decision-making process.

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