What are Target Retirement Funds?

Photo of author
Written By Mark

Mark is the co-owner of RetiringStrategy.com and has many years of experience in financial markets. 

Target retirement funds go by many names, including:

  • Life-cycle funds
  • Target-maturity funds
  • Target-date retirement funds

Funds in this category have seen tremendous popularity growth since 2004. As a matter of fact, several fund companies generate nearly half their sales from these.

Before you dive into these funds yourself, you should know the background behind them, the fundamentals involved, and the benefits and drawbacks of such funds.

The Story Behind Target Retirement Funds

There have been asset allocation funds around for lots of years. In the early days, they consisted within one fund company of having:

  • Domestic stocks
  • Foreign stocks
  • Bond funds
  • Money market funds

The allocations would vary based on the discretion of the fund managers given general market conditions and their changes. Some fund companies wound up expanding their allocations to include different risk levels associated with growth objectives. Income allocation funds also saw eventual inclusion.

Certain fund companies started emphasizing asset allocation funds where they included the estimated retirement date for the investor. T. Rowe Price did this in the final quarter of 2002.

Vanguard followed suit a year later. In these funds, the companies behind them thought that the concept of a fund of funds could be more easily sold to investors when the focus was on a particular goal, in this case, retirement.

Also, these fund companies thought that target retirement funds might appeal to investors who wanted to save for retirement but didn’t want to hire a financial advisor for it or do their own exhaustive research in terms of portfolio recommendations. This idea could also benefit companies proposing 401(k) plans because it could:

  1. Simplify the investment decisions that participants had to make
  2. Minimize the possible dilemma of the company’s fiduciary responsibility

The Fundamentals

Target retirement funds use the fund of funds method but with a particular time horizon. This reduces the allocation of equity funding in lieu of more bond fund allocation while the target date draws closer.

Different fund companies use their own allocation percentages. While some trend in the more conservative direction with higher allocations of bonds, some get even more aggressive with their stock allocations, even if the time horizons are similar.

No matter the specific allocations, a target retirement fund has certain characteristics that are deemed ideal. Diversification is a big one, with invested resources spread out over many categories of equity and bond funds. Many target funds include:

  • A variety of high-yield, government, and corporate funds in their bond allocations
  • Foreign or international equity funds
  • Small-, mid-, and large-cap domestic stock funds

Given that every target fund has multiple individual funds from a common fund company, it’s crucial that investors look over the underlying holdings.

Each one of the individual funds needs to have a good performance history, a clearly stated strategy, operating expenses that are below average, and experienced management.

Any retirement fund is best off when it’s no-load, as there’s no logic for investors to pay these kinds of funds commissions.

For a good comparison, the Morningstar Fund divides target retirement funds into groups incrementally divided by periods of five years starting with 2010. There were earlier three groups, but it was too overly broad for precise comparison.

Choose “domestic” for the fund type, pick the target-date range you deem appropriate for the fund category, and then input any other criteria before you hit Submit.

T. Rowe Price provides around a dozen actively managed individual funds, along with an index 500 fund for their current target fund offerings. Vanguard has about half as many. They are for both companies of course no-load.

Personally, I don’t think investors need to higher than 14 underlying holdings in any target retirement fund, as this would risk fund category overlap.

That’s where multiple funds have identical characteristics and create needless duplication. This can be a very common mistake in terms of mutual fund investing.

Advantages and Disadvantages

The biggest benefit of target retirement funds is how investors can use them for a simple, single solution for stock and bond allocations oriented towards a certain retirement date.

Investors don’t have to worry about keeping their diversification mixture balanced now or in the future. Such funds work well for many 401(k) plans given that many participants:

  1. Don’t personally have financial advisors available to them
  2. Get quickly overwhelmed by how many fund choices there are
  3. Find that figuring out a proper allocation strategy is perplexing, to say the least

On the other hand, a huge downside to target retirement funds is how they often lack the usual risk tolerance levels of aggressive, moderate, and conservative. Some financial advisors actually look at these funds as being too “cookie-cutter”, since they’re designed in single sizes applied to all investors.

Given how unlikely it is that a 401(k) plan would provide its collective target funds from multiple fund families, an investor would choose a target fund based on their current time horizon but be stuck with the risk tolerance level that the fund family has designated for it.

That company’s decided risk tolerance level might not be the same as yours. As such, you might be taking more or less risk than you want.

Not every fund company has the same fund categories or allocations. For instance, when you look over the broad horizon time spectrum, you can see that T. Rowe Price has their stock percentage higher, including more emphasis on mid-caps and even individual foreign funds as compared to Vanguard.

To be sure, though, Vanguard has caught up. Investors that are very conservative in terms of their risk tolerance might want to include very conservative funds within their 401(k) selections.

Target retirement funds also have a possible drawback of including individual funds that are mediocre in terms of performance or even do poorly. This would obviously drag returns down. Before you commit to individual funds, look into their long-term performance from that past.

Another possible drawback, particularly in the light of serious economic turmoil, is that some target retirement funds might have too much allocated into equities as the retirement date draws close.

Such investors should alter their allocations in other holdings, be they IRA, 401(k), or other various taxable accounts so that their comprehensive portfolio allocation remains appropriate.

Retirement Income Funds Aren’t the Same

Target retirement funds aren’t the same as retirement income funds, many of which started up around 2008. A retirement income fund invests in both equities and bonds with a strategy of managed payouts.

These kinds of funds promise their investors periodic payments before a particular expiration date. When the expiration date hits, the account will be zero.

Specific income payments aren’t guaranteed. They’re contingent upon fixed asset percentages, and they’re subjected to the volatility of the fund holdings. Also, payments are annually reset in order to reflect fund gains or losses from the prior year. In a target retirement fund, you decide on the particulars.

Key Takeaways about target retirement funds

Target retirement funds can be a worthy choice for those investors who would like the simplicity of selecting a single fund instead of putting together an entire portfolio for retirement.

They work particularly well in 401(k) plans. These funds might even boost 401(k) participation given their one-step simple nature that includes automatic diversification and allocation rebalancing over time.

On the other hand, investors that do research on their own or can use a professional advisor will probably opt for a customized portfolio designed to specifically address their own risk tolerances, time horizons, and return goals.

Leave a Comment