In recent years, a growing trend in the 401(k) space has been the use of target date mutual funds.

Target Date Mutual Funds

A target date mutual fund is a fund in the hybrid category that automatically resets the asset mix of stocks, bonds and cash equivalents in its portfolio according to a selected time frame that is appropriate for a particular investor. In simpler terms, an investor can purchase a target date fund based on their anticipated retirement date and the fund will automatically become more conservative as the investor approaches retirement.

This is often times a suitable investment for the average investor or participant in a 401(k) plan that would not typically make allocation adjustments on their own. During the financial crisis of 2008 and 2009, many investors approaching retirement were overexposed to the stock market and lost half of their savings with no time to make it back before retirement. This is where the benefit of a well-managed target date fund would have been useful as investors who needed an allocation change as they approached retirement would have got it. Emphasis on the well-managed.

At year end 2013, there was approximately $595.5 billion dollars invested in target date mutual funds, up from approximately $111.9 billion in 2006 based on a study conducted by Morningstar. With so much money being placed in these funds, it is important to know how they work and what to look for when choosing the correct fund for your risk tolerance and time horizon.

As mentioned previously, the allocation of assets within a target date fund will automatically rebalance throughout the life of the investment to focus more on income. With that being said, how does the rebalancing happen and how often does the rebalancing take place? The rebalancing takes place automatically when fund managers of that target date fund determine the allocation in the fund no longer meets its intentions. It is argued that most target date mutual funds do not rebalance nearly enough as some can be as long as 4-5 years.

It is important to know that the date of a target date fund is the date the investor plans to retire and is not the date in which the fund is at its most conservative allocation. Fund families operate their target date mutual funds very differently. For example, one fund family may have a 2020 fund that is 30% stocks and 70% bonds compared to another more aggressive fund family that is allocated 60% stocks and 40% bonds in their 2020 target date fund.

There are arguments for both allocations. Since an investor is at their retirement age, they should typically be more conservative. On the other hand, just because the investor hit their retirement age they may not be taking distributions from the account for another 5-10 years, and therefore could possibly achieve more growth.

A target date fund can be a suitable investment option for investors who would like a hands off approach in their 401(k), but participants must be aware that there is still due diligence necessary throughout the life of the investment. Below is a chart showing the results of a study conducted by Morningstar in 2010. It shows the allocation of target date mutual funds for different fund families during the financial crisis of 2008 and 2009. These target date mutual funds were meant for investors retiring in 2010 and therefore should have been allocated in a way that would not over expose them to a significant decline in the market two years from retirement.

As you can see, the equity (stock) allocation varies greatly between fund families and the over exposure led to significant declines in investors accounts. Too many people had their retirement account nearly halved two years from retirement which is devastating for an individuals quality of life.

There are definitely pitfalls to target date mutual funds but they can be appropriate in the right circumstances. It is important that investors are educated on what target date mutual funds are and more importantly what they are not. Here are a few takeaways that may help you determine which, if any, target date fund is appropriate for you.

Determine Your Risk Tolerance First

The first questions an investment advisor will typically have for a client are: “What is your time horizon?” and “What is your risk tolerance?”. Since target date mutual funds allocate assets for a group of investors based on a date in the future, the only piece that is somewhat satisfied is time horizon. Just because a group of investors have the same time horizon does not mean they should be invested the same way. Fund managers cannot allocate funds in a way that satisfies both questions without knowing the risk tolerance for each individual investor. That means, the risk tolerance piece relies on you. Two 45 year old investors may be 20 years from retirement and have completely different portfolio allocations due to their risk tolerance. One may be more aggressive and tolerant of stock market fluctuations while the other may be conservative and less willing to risk their savings. Even though each investor has the same time horizon, the appropriate portfolio for each would vary greatly. It is important to know your risk tolerance and apply that knowledge to the appropriate target date fund.

Research the Different Target Date Fund Options

As shown in the chart on the previous page, the asset allocation for a target date fund for one fund family could be drastically different when compared to the same target date fund for another fund family. This can be confusing for investors which is why it is important to research the fund and the current allocation before investing. The charts below show the asset allocation of two 2020 target date mutual funds from different families.

Both target date mutual funds are the same in terms of retirement date but drastically different in exposure to the stock market. The MFS 2020 fund with approximately 63% allocated to bonds/cash and 37% to stocks is a much more conservative portfolio than the Fidelity 2020, which is approximately 37% bonds/cash and 63% stocks. An investor with 5 years to retirement could have very different objectives with their retirement account and therefore each fund may be appropriate as a 2020 fund. An over exposure to the stock market for someone retiring in 5 years could be devastating as shown in 2008/2009 which is why it is important for each individual to determine their time horizon, risk tolerance, and investment objectives when selecting the correct target date fund for their portfolio.

Difference Between Target Date and Active Management

Although target date mutual funds are often referred to as “set it and forget it”, there are a number of factors that must be taken into consideration. Most target date mutual funds are typically managed exclusively on time horizon. Fund managers traditionally do not make significant allocation adjustments to these types of funds based on changing market conditions which can leave investors exposed to big drops in the stock market as they approach retirement. Investors within 10 years to retirement should work closely with their investment advisor to make sure they have the right mix of stocks and bonds in their portfolio. 

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.