The use of target-date funds by 401(k) participants continues to grow. On the surface, these are a very attractive option for many people. You pick the fund with a target date near your anticipated retirement date, click on this choice, and forget about it.
Unfortunately, nothing is quite that easy. At the very least, investors should understand what they are investing in. Here are four tips for looking under the hood of the target-date funds offered in your plan as you decide whether or not to go the target-date fund route.
Look at the underlying investments in the funds. The three biggest providers of target-date funds are Fidelity, T. Rowe Price, and Vanguard. Together, they represent 80 percent of the market. All three of these firms use a mix of their own proprietary funds as the underlying investments. In the case of T. Rowe Price, this is a cross section of the funds offered to investors. Vanguard uses a mix of its low-cost index products. Fidelity is moving towards using a number of its “series” funds, which are mutual funds with distinct tickers that are designed exclusively for use in Fidelity’s Freedom funds. There is also a mix of several funds from Fidelity’s regular fund lineup.
There are a few target-date funds that utilize funds from different families, and even some with ETFs as the underlying investments. Regardless, it does pay to look at the quality of the underlying holdings. While the key is asset allocation, it is still better to have a fund of top quality funds vs. one with mediocre holdings.
Is the philosophy to or through retirement? Vanguard, Fidelity, and T. Rowe Price all go into their glide paths after age 65, with T. Rowe Price having the latest start to its glide path. The glide path is the point at which the allocation to equities flattens out into retirement mode. The assumption that most target-date fund providers make is that you will stay invested in their fund until you die. Given the mobility of today’s work force, this may or may not be a valid assumption for you, but it will have an impact on how quickly the fund you select lightens its equity exposure.
Check on the fund’s expenses. For many target-date funds, the aggregate expenses are simply the weighted average of the underlying holdings. For example, Vanguard’s average expense ratio across its series of target-date funds is a very low 0.18 percent. Some other families of target-date funds add in a management fee on top of the expenses of the underlying funds. Low expenses are important with target-date funds just as they are with any mutual fund. Low expenses do not ensure superior returns, but they are a great starting point for investors.
Take a look at the asset classes used in the funds. Most of the target-date families use large cap, small cap, and mid cap domestic equity funds; international and emerging markets equity funds; and domestic fixed-income funds. Others have diversified over the years and use asset classes such as TIPS (inflation-protected Treasury bonds), high yield bonds, international fixed income, emerging markets debt, real estate, commodities, and long/short funds. While none of these asset classes are good or bad by themselves, as an investor it is incumbent upon you to understand how the fund manager is investing on your behalf.
Target-date funds might be the right choice for some or all of your retirement plan dollars; however, you should make that decision as an informed investor. Investing in a fund that doesn’t meet your needs can be a recipe for a retirement savings shortfall.
Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Roger also blogs at Chicago Financial Planner.