Target Date Funds
June 11, 2024
By Barbara O'Neill, CFP®, AFC®
2024 is the 30th anniversary of target-date funds (TDFs), with the first TDF created in 1994. Also known as lifecycle and age-based funds, TDFs have grown in popularity ever since and are the default option for auto-enrollment in most 401(k) plans and the Thrift Savings Plan for service members. TDFs may also be available in 403(b) plans depending on the vendors that are available to plan participants and the specific investments that these vendors offer.
TDFs are diversified mutual funds with a portfolio consisting of stocks, bonds, and/or cash equivalent assets. They gradually become more conservative (read: a smaller percentage of stock in the fund portfolio) and income-oriented as the “target date” in their name (e.g., 2050 Fund) approaches and, once it is reached, going forward. Investors often select a fund with a date that matches, or is close to, their expected year of retirement.
TDF dates are spaced out at 5- or 10-year intervals (e.g., 2040, 2045, etc.), depending on the mutual fund provider. Most TDFs are “funds of funds” with underlying funds from the same fund family. Examples of TDFs from 403bwise Green rated vendors include Fidelity Freedom funds, Vanguard Target Retirement funds, and T. Rowe Price Retirement [DATE] funds.
This post provides a primer on TDFs including their logistics, advantages and disadvantages, selection criteria, and expenses. It also describes TDFs available from the Green vendors noted above and concludes with a summary of research about TDFs, three “need to know” facts, and six take-away action steps.
How TDFs Work
TDFs are based on the long-standing assumption that investors should have less stock and more fixed-income securities in their portfolio as they get older. Instead of investors making asset allocation weighting changes themselves over time, TDFs make them automatically. For example, a target-date fund might start out with 80% of its portfolio invested in stock funds and gradually shift to 40% over the course of three decades.
A defining characteristic of TDFs is their glide path, which is the planned schedule for changes in asset weightings over time as the fund approaches the target date and beyond. Pictured like a descending staircase, glide paths slope downward and determine how frequently and by how much the stock weighting decreases. Glide paths are a critical factor in TDF performance and vary among TDF fund providers. Three key elements of glide paths are their initial equity (stock) allocation, the slope of the glide path, and the equity landing point.
There are two types of TDF glide paths: to and through retirement. “To” glide path TDFs assume that the target date is the end of the slope and, at that point, the portfolio’s stock percentage weighting and investment mix remains static. “Through” glide path TDFs continue to decrease the stock percentage for a designated number of years after the target date before leveling off.
The “landing point” of a glide path is where a TDF reaches its lowest stock percentage allocation. Not surprisingly, TDFs with different glide paths and landing points have very different risk profiles and performance histories. All TDFs are not alike!
TDF Advantages
- Portfolio rebalancing is done automatically
- Provides diversification across asset classes and time
- Offers a low-maintenance starting point for new investors
- Includes 5- or 10- year time intervals to meet investors’ needs
- Designed to be a continuing post-retirement investment for older adults
- Takes the guesswork out of the process of reducing investment risk over time
TDF Disadvantages
- Portfolio does not address individual risk tolerance levels
- Has two layers of fees: the TDF itself and its underlying funds
- Can lose money and does not guarantee adequate retirement income
- Characteristics vary among TDF providers, making comparisons difficult
- Portfolio does not address differences in retirement resources (e.g., pension, Social Security)
TDFs and Risk Tolerance
TDFs make the flawed assumption that everyone at the same age has the same investment risk tolerance. This is simply not the case. Rather, people differ in how much risk they can emotionally withstand; i.e., their “sleep at night factor.” This tool from the University of Missouri can help you assess your tolerance for risk.
Another factor to consider: guaranteed income sources. When people have a pension, especially a generous one that pays all of their living expenses, post-retirement income (e.g., from a job, freelancing, rent) and/or Social Security, they can worry less about portfolio performance and take more risk with the equity portion of their portfolio. This can lead to the need for “workarounds” that increase the complexity of TDF selection.
For example, let’s assume some teachers are planning to retire in 2050. If they are conservative investors, they might decide to “go short” (2045 or earlier) in their TDF selection. Conversely, more aggressive investors and those with solid pensions might “go long” (2055 or beyond) to keep more stock in their TDF longer.
TDF Expenses
Many TDFs are “funds of funds” that create their portfolios by investing in other mutual funds. Thus, investors pay two sets of expenses: for a TDF itself and its underlying funds. The lower a TDF’s expense ratio (expenses as a percentage of fund assets), the lower the cost to investors so they keep more of what they earn.
TDF expense ratios can range from as low as 0.08% to more than 1.5%. The average expense ratio for TDFs, excluding Vanguard, in December 2023 was 0.44% according to Morningstar. This is 11 times the 0.04% expense ratio of the Vanguard Total Stock Market Index Fund (VTSAX). Stated another way, investors will generally pay more (and give up some return) in exchange for the simplicity that TDFs provide.
TDF Selection Criteria
Like any mutual fund, there are three key factors to consider when selecting a TDF: 1. the fund’s objective, composition, and investment style (i.e., glide path), 2. historical performance relative to peer funds, and 3. fees and expense ratio. Small differences in expenses can translate into large differences in returns over time.
Information about all three factors can be found online and in a TDF prospectus. Read it! Look for an expense ratio less than 0.20%. Funds with aggressive investment strategies (i.e., more distant target dates) may have higher expense ratios than more conservative funds because there is more stock to manage.
Understand a TDF’s underlying assets: are they active or passive mutual funds? Passively managed index funds will cost less. Also understand a TDF’s glide path and equity landing point: is it a “to” or “through” retirement TDF? Are you happy with the ongoing and final asset allocation?
Finally, how does a TDF match your risk tolerance level and planned retirement date? Investors planning to retire in between two TDF target dates can choose the nearest date (up or down) in synch with their risk tolerance. For example, if planning to retire in 2042, they might select a 2040, 2045, or 2050 TDF.
Green Vendor TDF Options
Vanguard, a 403bwise Green + vendor, offers a selection of 12 All-In-One Target Date Funds on its product list for 403(b) plans with dates ranging from Target Retirement 2020 to Target Date 2070, plus Target Retirement Income (VTINX), a fund designed for investors already in retirement. The average Vanguard TDF expense ratio is 0.08%. Vanguard has a helpful table (scroll to middle of page) that matches a person’s birth year with a specific TDF. For example, Target Retirement 2060 for investors born between 1993 and 1997.
Fidelity, another Green+ vendor, has a wide selection of Fidelity Freedom Funds on its non-profit organization product list with target dates ranging from Fidelity Freedom 2010 K (an income-oriented fund past its target date) to Fidelity Freedom 2065 K for Gen Z investors. Like, Vanguard, expense ratios are low (e.g., 0.08% for 2010 and 2025 and 0.09% for 2065).
T. Rowe Price, a Green vendor, has a 403(b) plan product list with a wide range of investment choices including TDFs with dates ranging from 2005 to 2065. Its TDF expense ratios are higher than Vanguard and Fidelity, however, ranging (in June 2024) from 0.49% for the Retirement 2005 Fund and Retirement 2010 Fund to 0.64% for the Retirement 2055, Retirement 2060, and Retirement 2065 funds.
Research Results
A study conducted by Fisch Financial explored TDFs as a 403(b) plan choice for educators and concluded that they were a good, but not the best, choice. The reason? Most public school teachers have a defined benefit pension plan that pays a guaranteed lifetime income based on highest average salary and years of service.
Teachers with long tenure and decent salaries (or teacher couples) can often live entirely off their pension and leave their 403(b) accounts alone, with the exception of required minimum distributions (RMDs). They are, therefore, insulated from sequence of returns risk, which is the risk of a stock market downturn early in retirement. If money is withdrawn during this “fragile” time, asset value can be very difficult to recover.
The study modeled investment results for teachers with pensions and concluded they should consider having 100% of their retirement investments in stocks or as much as their risk tolerance can stand. After 30 years, someone with a TDF would have $156,000 less than a 100% stock investment. After 40 years, the difference is $868,000 less and, after 50 years (e.g., age 23 to 73), $4.4 million less! Take-aways: long-term investors in TDFs cannot match the returns of 100% stocks and a pension provides “cover” to invest more aggressively.
In another study, researchers at the Employee Benefit Research Institute found that, without TDFs as an investment option, the proportion of equity investments in retirement plans is much greater for males than females, especially at younger ages. With at least some exposure to TDFs, however, there is an “equalizing effect” and gendered asset allocation differences are greatly reduced.
Three (More) Things
- TDFs work best as a stand-alone retirement plan investment. When they are combined with other investments, or several TDF target dates are selected, their asset allocation is altered, which contradicts the whole premise of using them.
- TDFs are best suited for 403(b) plan participants who are inexperienced investors, do not pay attention to financial news, and desire a “low maintenance” approach to retirement planning.
- A good analogy for TDFs is a meal starter kit, where all of the ingredients are pre-selected and just need to be stir-fried together. Like meal kits, TDFs are valued for their “set it and forget it” convenience.
Six Smart Strategies
No. 1: Read the TDF Prospectus — Examine a TDF’s expense ratio and review its past performance history, underlying mutual funds, and glide path structure to determine whether it is “to” or “through” retirement.
No. 2: Consider Increasing Equity Exposure — Get an estimate of your future pension benefit. If it is significant and you have a moderate to aggressive risk tolerance, consider investing more of your 403(b) in equity investments as per the Fisch Financial study.
No. 3: Compare TDFs with Other Investments — Compare the cost and convenience of TDFs with other 403(b) plan options such as index funds. Index funds often have a lower expense ratio than TDFs but will require ongoing rebalancing. TDFs do this for you.
No. 4: Stay Involved — Do not make the mistake of ignoring a TDF just because you “set it” and it automatically adjusts its portfolio over time. Stay actively involved by tracking its performance and reading updated prospectuses.
No. 5: Seek Out Low Fees — Some TDFs have high expense ratios, which erode investment earnings. If you decide to invest in a TDF, select one with low expenses: 0.20 or less vs. 1.0 or higher.
No. 6: Understand the Decumulation Phase — Learn how a TDF will adjust asset allocation and manage withdrawals throughout retirement. Some plan participants may live 30 or 40 years after the target date.
In Summary
TDFs are a 403(b) plan investment to consider if you have a vendor that offers them. Their defining characteristic is their glide path, which determines their asset mix over time. Knowing a TDF’s glide path is critical to understanding its risk profile. Not every TDF with the same target date is the same.
This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.
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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.