Planning for retirement? What you should know about target-date funds

March 20, 2014, 6:24 PM UTC
Keeping your savings leveled.

FORTUNE – More than 51 million Americans have an active 401(k) retirement account, according to the Investment Company Institute.  And if recent statistics from Vanguard hold across the category – more than half have at least some of their money in a target-date fund. That’s a lot of dough and it’s growing fast.  According to BrightScope, target-date fund balances overall hit $500 billion in assets in 2012.  The company is estimating them to reach $2 trillion by 2020.

In many ways, that’s a good thing.  That shift has tempered the bi-polar tendencies of many 401(k) investors.   According to Vanguard, 10 years ago, 13% of their self-directed 401(k) investors held no stocks and 22% held only stocks.   No matter how you slice it, those investors were taking too little or too much risk.  Last year those numbers dropped to 10% and 13%, respectively – a result, at least in part, of making TDFs the default option on many retirement plans.

I’ve been a proponent of TDFs over the years.  I like the way they help humans who say they are going to rebalance their portfolios but never seem to get around to it stay at least in the vicinity of the track. Which is not to say I think they’re perfect.

TDFs aren’t baskets of stocks and bonds, but funds comprised of other mutual funds – from a single mutual fund family.  Therein lies the problem says Financial advisor Tim Maurer, director of personal finance for the BAM Alliance.   “Very rarely,” he says does any one fund family have the one of the best funds for every given asset class.  He argues that if you’re willing to put in even a few hours of time (“you may have to read a book,” he notes) you should be able to put together a better portfolio for your specific needs.

That said, if you’re going the TDF route, thinking about going the TDF route, or suspect you’re on the TDF route, having taken no actions whatsoever, here are a few questions you should ask about your fund options.

  • How expensive is it? According a report from BrightScope, the 401(k) plan rating firm, released last summer, average fees on a TDF are 70 basis points.  The good news, says Brooks Herman, head of data and research for the company, is that they’re falling.  A few years ago they were 72 basis points.  “We’re excited about that,” he says.   But if you’re paying significantly more than that, you’re paying too much.”
  • What’s in it?  The other trend BrightScope has noticed is increased exposure within TDFs to non-traditional assets classes, commodities and real estate for example.  “More and more are buying these assets as a means of diversification within the glide path (more on this in a sec) and against stock and bond holdings.”  It’s still a small percentage, but if you’re a believer that you should know what you own as I am, you should at least look at the menu before ordering.
  • Ah, the glide path.  What is that again?  The glide path is the bond to equity ratio as you approach retirement.  The way TDFs work, the farther away you are from retirement the more stock exposure – and more risk – you’ll have.  As you get closer, you’ll have less stock exposure and be invested more conservatively.   “They’re built for set it and forget it,” Herman notes.  “But the rub is that all glide paths are different.  Some asset managers think you should have 50% equity when you retire, some say 20%, some say 15%.”  You should know what the glide path looks like and assess whether you’re comfortable with that percentage in stocks at retirement.   This information is published in the prospectus, a document many – if not most – TDF investors haven’t cracked.  “I can count on one hand how many people I know who have read one of those,” says Herman.  “But the data is there and it’s important.” So, ummm, can I really set it and forget it?  You can.  But that doesn’t mean you should.  As Herman aptly put it: “Just because you wear a seatbelt doesn’t mean you should drive 100 miles an hour.”

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