Target-date funds are retirement funds that morph over time as you get closer to retirement. The funds change their allocation among stocks, bonds and cash equivalents based on your projected retirement date. Investors typically select a fund with a target date closest to their anticipated retirement date.
The allocation to stocks is reduced as retirement nears, making the portfolio more conservative. The primary benefit of these funds is the autopilot feature, which permits investors to “set it and forget it.” There is no need to rebalance or manually change the allocation over time, since the fund handles those functions without input from the investor.
I view the growth of target-date funds as a positive development for investors. According to Morningstar’s 2013 “Target-Date Series Research Paper,” during the first quarter of 2013, these funds’ assets surpassed $500 billion.
The target-date industry is dominated by Vanguard, Fidelity and T. Rowe Price. These three firms have captured about 75 percent of the assets invested in these funds.
Consider these factors when selecting target-date funds:
1. Active vs. passive. Target-date funds consist of underlying funds. Those funds can be all index, all active or a combination of both.
Fidelity, Vanguard and TIAA-CREF all offer target-date funds that are exclusively index-based. Some of the smaller target-date fund families have joined the shift to index-based funds, including JPMorgan, BlackRock, ING and John Hancock.
Investors are showing a preference for target-date funds that are index-based. In 2012, the Vanguard Target Retirement series led the pack for asset inflows, with almost $20 billion in new assets.
In selecting a target-date fund, you should consider the overwhelming data showing that a majority of index funds outperform their actively managed counterparts in any one year and over the long term, according to data provided by the S&P Indices vs. Active Scorecard.
2. Fees. Vanguard is the lowest fee provider among the major fund families offering target-date funds. Its asset-weighted fee is 0.15 percent, which is sharply lower than the 2012 asset-weighted average fee of 0.91 percent for the industry. Fidelity is not far behind. Its asset-weighted fee for its Freedom Index series of funds is 0.19 percent. At the other end of the fee spectrum, the Legg Mason Target Retirement Series has an asset-weighted expense ratio of a whopping 1.47 percent.
Since fees affect returns, you should carefully consider the fees of any target-date fund.
3. Size of fund. You may be surprised to learn that four target-date funds closed in 2011: American Independence, Columbia, Oppenheimer and Goldman Sachs. The Morningstar analysis identified target-date funds run by Putnam, DWS, Mainstay and AllianceBerstein as having similarities with the closed funds.
Before investing in a target-date fund, you should do some due diligence to limit the possibility that your selected fund will close or merge. The five target-date funds with the most assets are Fidelity, Vanguard, T. Rowe Price, Principal Funds and Wells Fargo Advantage.
4. Glide path. The Morningstar study found little difference among target-date funds when it compared the possibility of running out of money through age 85. However, after that age, funds with a higher allocation to stocks had a greater likelihood of success through age 95.
If you have significant savings outside of your target investment, a lower allocation to stocks might be appropriate for you. If not, you may have to weather the higher volatility of a more aggressive allocation.
5. Broad diversification. Diversification reduces risk. Since 2005, the percentage of international stocks in the average 2040 fund stock allocation has increased from 24 percent to 36 percent. Since 2008, there has also been an increase in foreign bond exposure.
Look carefully at the holdings of the target-date funds you are considering. Exposure to international stocks and foreign bonds should be considered a plus.
6. Stewardship. Morningstar looked at the firms managing target-date funds and assessed their corporate culture, governance practices and regulatory history. The metrics used included fund manager tenure, retention and investment in fund shares. It found that companies with “strong firmwide quantitative metrics” had better risk-adjusted returns.
The firms that scored the highest stewardship ratings were MFS Lifetime Series, Manning & Napier Target Series, American Funds Target Date Retirement Series, Vanguard Target Retirements Series and T. Rowe Price Retirement Series.
Although no single factor should govern your determination of the right target-date fund, looking at all of these issues should help you make a prudent choice.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, “The Smartest Sales Book You’ll Ever Read,” will be published March 3, 2014.