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Hidden Differences in Target Date Funds

February 26, 2019 BY Mark Haser

Target Date Funds are mutual funds that automatically adjust their asset allocation over time as they approach a specified “target date,” often retirement or college. Since the funds adjust themselves over time, you can hold them for the long-term while taking a “hands-off” approach. This can help you reduce the risk of behavioral errors while also simplifying your investment portfolio. However, this is not to say that target date funds are all the same. Let’s look at two of the biggest differences that you’re likely to run into when selecting between target date funds.

1. An overly conservative (or overly aggressive) glide path

Glide path is the term used to describe how the target date fund adjusts its asset allocation over time. For example, assume a target date fund starts at 90% stocks / 10% bonds and has a date that is 30 years in the future. The fund’s glide path might dictate that it decrease the stock holdings by 10% while increasing bonds by 10% every five years up until it reaches the target date. When it reaches the target date, the fund will be at an allocation of 30% stocks / 70% bonds.

Some investors find the typical glide path to be overly conservative, reducing their exposure to stocks (and therefore their greatest growth potential) too far in advance of the target date. Other investors find glide paths to be too aggressive. By doing a little research you can find a target date fund with a glide path that best matches your own goals and tolerance for risk. It’s also important simply to recognize that glide paths are set by the fund and, because of this, you sacrifice some level of flexibility over your asset allocation.

Example of a Glide Path

2. Active vs. Passive Target Date Funds

The second thing to be aware of is that investment companies can create target date funds with very different underlying investments. For example, the Vanguard Target Retirement 2050 Fund is composed of two stock index funds and two bond index funds. Contrast this with the Fidelity Freedom 2050 Fund, which is composed of 26 different actively managed funds. Vanguard and Fidelity have different approaches to creating target date funds that might otherwise go unnoticed. By looking at the underlying investments, you can select a target date fund that most closely aligns with your preference for a passive or active approach.

In comparing target date funds, you should also look at the expense ratios to make sure you’re not paying more than comparable funds. Keep in mind that actively managed funds tend to have higher expenses than passively managed funds. For example, the Vanguard Target Retirement 2050 Fund, which uses index funds, has an expense ratio of 0.15% compared to the Fidelity Freedom 2050 Fund expense ratio of 0.75%. While fees should not be the only consideration, research shows that lower fees tend to correlate with higher performance over long periods of time.

Conclusion

Given the simplicity and instant diversification of target date funds, it’s not surprising that they are predicted to capture 85% of participant contributions in retirement plans by 2021[1]. If you intend to include your contributions in this 85%, be sure to look closely at the glide path and the fund’s underlying investments to fully understand how it actually invests your money.

Want to know more about target date funds? Check out our Brief: Should You Invest in a Target Date Fund?


[1] According to Holly Verdeyen, senior director of defined contribution investments for Russell Investments

POSTED IN: blog, Investing

Mark Haser, M.B.A., is a financial planner at Artemis Advisors. His areas of interest include retirement and education planning, risk management, and cash flow management.

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