How To Pick a Target Date Fund

Last Updated Apr 16, 2010 12:50 PM EDT

Earlier this week, CBS MoneyWatch blogger Linda Stern wrote about the popularity of target date funds in her post Target-Date Funds Surge 271 Percent Since 2005. Another CBS MoneyWatch blogger, Carla Fried, recently discussed the unwarranted criticism of these funds in her post More Proof Target Funds Good Retirement Solution. Let me add my voice to the chorus of fans of target date funds, but with an important caveat.

Here's what I like about target date funds. They're comprised of an asset allocation between various classes of investments that the investment manager considers appropriate today for a given future retirement date. All target date funds include stocks, bonds and cash; some funds diversify more broadly and also include small cap stocks, international stocks and/or bonds, and real estate investments. As the target retirement date approaches, the investment manager reduces the risk of market volatility by shifting assets from stocks and other risky investments into bonds and cash (this is called the "glide path"). I like the automatic rebalancing over time, since many investors don't have the discipline, time, or focus to accomplish this on their own.

So what's the caveat? Don't turn off your brain, as many investors did when they invested in these funds before the meltdown. Somehow they got the message that they could invest in a target date fund and then forget all about it, thinking "Everything will turn out OK." It's the "Look, ma! No hands" approach to investing.

Many people who invested in target date funds were surprised and disappointed when their funds lost money in 2008. Even funds with a 2010 target date lost money. But it's not uncommon for 2010 target date funds to currently invest about 50% of their assets in stocks, since the investment managers believe that people close to or in retirement should still have significant amounts invested in the stock market. If an investor had taken the time to learn about the allocation to equities, he or she wouldn't have been surprised when the funds lost money in 2008.

Let's say you're contemplating investing in one of these funds. How do you go about selecting the target date fund that's best for you? The simple answer is, don't select one based on your target retirement date. I know this sounds a little contradictory, but stay with me for a bit. Here I'll talk about what to do if you're offered a lineup of target date funds in your 401(k) plan and you don't have the option of considering other target date fund families. (A future post will cover the situation where you have complete freedom in selecting a target date fund.)

If you're considering a target date fund, don't just blindly decide on your retirement date and then pick the corresponding target date fund. It's much better to look at the fund's specific asset allocation between stocks, bonds, cash, and real estate (if applicable), and then decide if that allocation is right for you. Selecting a fund based on its asset allocation might even result in you selecting a target date fund with a stated retirement date that's different from your own retirement date -- and that's OK.

Keep in mind that different mutual fund families can have different opinions on the appropriate asset allocation for a specific retirement date. For example, Fidelity, T. Rowe Price, and Vanguard all offer 2020 target date funds for retirement dates in the period 2016 to 2020. Morningstar reports the following allocations between stocks and bonds/cash for these funds.

Note that there's considerable difference in allocation to stocks between the most conservative 2020 fund (Fidelity's with 60 percent invested in stocks) and the most aggressive fund (T. Rowe Price's with 73 percent invested in stocks). In a previous post, Asset Allocation: My Grandfather Had It Right, I stated that I was uncomfortable with asset allocations to stocks above 67 percent for people in their mid-50s and beyond. Suppose my 401(k) plan only offers target date funds from T. Rowe Price, and my target retirement date is between 2016 and 2020. If I followed my own guidelines, I could invest in their 2015 fund, which invests 65 percent of assets in stocks, or their 2010 fund, which invests 57 percent in stocks, rather than their 2020 fund.

Note the importance of paying attention to names. When compared to Fidelity's 2020 fund, T. Rowe Price's 2015 fund is more aggressively invested, and even their 2010 fund comes close to the Fidelity 2020 fund allocation to stocks.

There are other considerations for picking target funds, such as how glide path is structured, the performance of the funds, and their management expenses. I'll cover these topics in future posts.

The bottom line: It definitely pays to "look under the hood" of target date funds and not just rely on a number on the calendar!

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.