Target Date Funds: The Hassle-Free Way to Invest in Your 401k or IRA
by Dave Sterman
Many of us invest for one reason: to build a big enough nest egg for retirement. Good old-fashioned fund picking is the preferred route for many 401k and retirement investors, but can be a bit daunting for the novice investor. This reader's question addresses another type of that can provide you with a solid retirement strategy.
Q. "I'm a long way away from it, but I'm starting to think about investing for retirement. I've heard of these target date mutual year attached to them and you pick the one that's closest to the year that you expect to retire. How do those work exactly? And are they good?"with a
-- Paul, Manhattan, Kan.
A. Paul, you're talking about target date funds -- and the short answer is, yes, they are a good vehicle if you choose the right ones. Before we look at your various options with these funds, let's see how they work.
What is a target date fund? How do target date funds work?
Target date funds (also called lifecycle funds) buy and hold a set of assets and place them into a fund that is aimed at investors of a specific age. Funds that are aimed at people close to retirement load up on low-risk investments such as bonds and Treasury Bills, along with stocks that sport stable and solid dividend yields.
For investors who don't plan to retire for several decades, there are target date funds that own a riskier but perhaps higher-returning set of assets. This follows the longstanding investing maxim that the greater the number of years until retirement, the more aggressive an investor should be. These funds steadily adjust their mix of holdings as the years pass, focusing on more conservative investments as the end date of the portfolio draws closer.
Though these funds have been around for two decades, they've soared in popularity since the Pension Protection Act (PPA) of 2006. That act allowed employers to automatically enroll their employees into 401(k) plans, and target-date funds became an attractive option, especially for novice investors.
The Best Target Date Funds
Given the soaring popularity of target date funds, financial services providers now offer a wide range of investment options. Fidelity, Vanguard and T. Rowe Price have the widest range of offerings, though other fund firms also now sponsor target-date funds.
It's probably best to stick with the Big Three, as smaller fund firms are always at risk of shuttering a fund that has too few assets under management.
In my opinion, the best target date fund families for you to consider include:
1. Fidelity's Freedom Funds, each of which has a date attached to them. For example, the Freedom 2030 fund is suitable for investors in mid-careers, while the Freedom 2055 is ideal for investors who have only recently joined the workforce. While these funds carry annual expense ratios of between 0.6% and 0.8% -- three to six times more than a low-cost ETF -- they still offer good Morningstar ratings and the simplicity of a ready-made portfolio.
2. T. Rowe Price Target Funds sport a reasonable annual expense ratio of around 0.7%, yet have delivered solid returns compared to the peer group in recent years. That's partially attributable to a more aggressive investing approach, which has paid off while the markets have rebounded in recent years, though fund-rating firm Morningstar believes that T. Rowe Price's fund managers have also proven to be especially adept stock pickers.
3. The Vanguard Target Retirement Funds get high marks for a fairly conservative approach. "The high-quality bias of the stock and bond portfolios caused these funds to lag their competitors during 2009's speculative-driven rally, but they held up better than most during 2008's financial crisis," according to Morningstar's analysts.
Perhaps the strongest endorsement for the Vanguard funds: a very low 0.16% annual expense ratio. Over the course of many years, the smaller bite from expenses means more money stays in your fund -- and not in the firm's coffers.
So, are target date funds good?
When people ask if an investment is good, often times I find they're referring to risk (i.e. the chance for loss) and performance (how much return to expect).
Keep in mind that investors in target date funds shouldn't equate low risk with no risk. Indeed, in the market meltdown of 2008 and early 2009, even the most conservative target-date funds slumped in value.
The good news: Those losses were eventually recovered, and these funds rose in tandem with the broader stock market over the following several years. To be able to invest in something that automatically rebalances according to your age and risk tolerance and still get performance that's par with the market? That sounds like a good deal to many people that would rather do something besides watch investment charts every month or quarter and make stressful decisions.
Still, as with any investment, you should expect target date funds to have bumps in the road as you wend your way toward retirement. As a good rule of thumb, I like to keep several years' worth of living expenses in short-term bonds and CDs on hand, so I can tap those more liquid funds if needed amidst another stock market rout.
All said, the right target date fund for you depends on your risk tolerance. Even among target date funds with similar expiration dates you'll find a vastly different mix of assets. That's why you should compare and contrast the holdings of funds offered by the leading 401(k) providers such as Fidelity, Vanguard, T. Rowe Price and others.
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