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Matt C. White

TARGET-DATE FUNDS are riding a wave of popularity. Morningstar reports that investors placed $170 billion into these funds in 2021, more than double their 2020 inflow. Morningstar also reports that, as of 2019, 58% of all 401(k) participants were invested in a target-date fund. That percentage is likely higher today.

It’s clear why the funds have become so popular. They can be an excellent solution for retirement savers who prefer a hands-off approach. To this end, many employer retirement plans use target-date funds as their default investment choice. But there is, I fear, a lack of education around what to expect from these products.

A recent AllianceBernstein study found that many target-date shareholders don’t understand how their funds work. This confusion could lead to significant overconfidence about retirement readiness. Among those surveyed:

  • 68% thought their funds were FDIC-insured.
  • 57% thought their funds would be invested in cash at retirement.
  • 50% thought their funds were guaranteed to meet their income needs in retirement.
  • 42% thought their funds were guaranteed to never lose value.

If you’re a regular HumbleDollar reader, you most likely are well aware that target-date funds don’t have any of these features. It’s possible, however, that some folks you know hold these misconceptions—and they may be shocked by the drubbing that many target funds have suffered in 2022.

Here are the two crucial concepts that every target-fund shareholder should understand:

Modular construction. There’s a Berkshire Hathaway-owned company headquartered in my town called Clayton Homes. Rather than build homes on site, the firm builds them in sections, or modules, in one of its facilities. Construction can happen in less than a week. Once built, the modules are transported to the home site, where they’re attached to each other atop the home’s foundation.

If you visited one of these homes, you’d never know that the entire structure was assembled this way. Clayton uses the same quality of materials, and meets the same state and local building codes, as site-built homes.

You can think of target-date construction the same way: Many target-date funds are built from a handful of different components that are then joined together. For example, Vanguard Target Retirement 2065 (symbol: VLXVX) holds Vanguard’s Total Stock Market Index Fund (53.3%), Total International Stock Index Fund (36.8%), Total Bond Market Index Fund (6.8%) and Total International Bond Index Fund (3.1%).

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Every provider builds its target-date funds a bit differently. Some use passive index funds, some use active funds and some use a blend. Stocks and bonds are the primary asset classes involved, but some target-date funds also dedicate a minor allocation to alternatives like real estate investment trusts and commodities. While each target-date fund is built with its own flavor, you won’t find any that are built with products that guarantee income or preservation of principal.

Glide path. A target-date fund’s investment mix changes automatically over time, often every five years. This is called the glide path. The purpose is to decrease fund volatility as the fundholder nears retirement. Some funds stop the glide path and keep the investment mix static at retirement, while others will change once or twice more.

Target-date funds are offered in series based on the estimated retirement year. Depending on when you want to retire, you could choose from a fund roster that includes a 2065 fund, 2060 fund, 2055 fund and so on. These are sometimes referred to as “vintages.”

Typically, the stock allocation decreases and the bond allocation increases as the fundholder moves down the glide path. For example, Vanguard Target Retirement 2025 (VTTVX) holds the same four funds as the 2065 fund, but with lower stock and higher bond allocations. It also has a 3% allocation to Vanguard’s Short-Term Inflation Protected Securities Index Fund.

The best part about the glide path is that it takes the investment decisions out of the hands of the fundholder. The years right before and right after retirement can be the most important in a person’s investing career. They can be fraught with worry about “not having enough.” By removing the allocation decisions, the glide path feature prevents fundholders from making emotional, ill-timed changes to their portfolio.

The bottom line: Target-date funds have numerous features that make them useful tools. It’s important, however, to be clear about what they are and aren’t designed to do. They provide portfolio growth during our accumulation years and risk management later on, but they don’t provide guaranteed income or guaranteed returns. Investors who want those features will need to look elsewhere.

Matt Christopher White is a CPA and CFP® who writes about money and apprenticeship to Jesus. He’s the author of “How to Love Money: Four Paradoxes that Breathe Life into Your Finances,” available at MattChristopherWhite.com. Matt is equally comfortable talking about Luke 6:43, Section 643 of the Internal Revenue Code and the 6-4-3 double play. There’s no place he’d rather be than with Sarah and their two girls, Lydia and Eliza, at their home in the foothills of the Smoky Mountains. Follow Matt on Twitter @WriteMattWhite and check out his earlier articles.

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mike schellenberger
mike schellenberger
2 months ago

My problem with TDFs is that you can’t sell bonds/stocks at the appropriate times. I also find their asset allocation and glide paths generally WAY to conservative for my likings especially with bond market as it has been over the past few years.

Rick Connor
Rick Connor
2 months ago

Thanks Matt. I’ve used TDF makeup to compare to my portfolio.

Matt Christopher White
Matt Christopher White
2 months ago
Reply to  Rick Connor

Thanks for reading, Rick! I love that idea. The TDF can make a great benchmark or model to emulate–for those who prefer to be more hands-on with their retirement investing.

William Perry
William Perry
2 months ago

Thanks Matt for your article which covers a number of the commonly misunderstood features of Target Date Funds (TDF).
For me is the typical annual cost of the TDF compared the annual cost of a simple broad base index fund is what drives my decision.
My 401(k) offerings include VFIAX (S&P 500) with a annual cost of 0.0004 and RFDTX (TD 2025) with a annual cost of 0.0070. The 17.5 times cost difference makes me willing to do what I consider minimal work to diversify my overall holdings. I get broad international diversity outside of my 401(k) through VTWAX (World Stock Index) at a cost of 0.0010 and I-Bonds bought at TreasuryDirect at no cost to me except for my time.
I am unaware if other 401(k) plans have similar expense differentials.

Matt Christopher White
Matt Christopher White
2 months ago
Reply to  William Perry

William and parkslope, thank you for reading and commenting! I agree; fees have to be a top-of-mind consideration. You can find TDFs built with index funds that will cost much less than the more costly examples that parkslope gave. For example, Schwab or Vanguard’s index series is .08% and Fidelity’s Freedom Fund index series is .12%. If you go with a TDF, you are paying at least something extra for the glide path–reducing the risk exposure for you as you near retirement. That extra fee could be well worth it in contrast to not making those adjustments at all. But if you can stay on top of doing the rebalancing yourself, you could definitely build your own portfolio with low-cost index funds for less than a TDF would cost.

parkslope
parkslope
2 months ago
Reply to  William Perry

I’m retired now but opted not to use TIAA’s target-date funds because of their high expenses. Current expenses with my former employer are .63% for 2015 and .81% for 2060.
I’m sure there are many employees who aren’t aware that target-date funds are usually more expensive.

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