TARGET-DATE FUNDS are riding a wave of popularity. Morningstar reports that investors placed $170 billion into these funds in 2021, more than double their 2020 inflow. Morningstar also reports that, as of 2019, 58% of all 401(k) participants were invested in a target-date fund. That percentage is likely higher today.
It’s clear why the funds have become so popular. They can be an excellent solution for retirement savers who prefer a hands-off approach. To this end, many employer retirement plans use target-date funds as their default investment choice. But there is, I fear, a lack of education around what to expect from these products.
A recent AllianceBernstein study found that many target-date shareholders don’t understand how their funds work. This confusion could lead to significant overconfidence about retirement readiness. Among those surveyed:
- 68% thought their funds were FDIC-insured.
- 57% thought their funds would be invested in cash at retirement.
- 50% thought their funds were guaranteed to meet their income needs in retirement.
- 42% thought their funds were guaranteed to never lose value.
If you’re a regular HumbleDollar reader, you most likely are well aware that target-date funds don’t have any of these features. It’s possible, however, that some folks you know hold these misconceptions—and they may be shocked by the drubbing that many target funds have suffered in 2022.
Here are the two crucial concepts that every target-fund shareholder should understand:
Modular construction. There’s a Berkshire Hathaway-owned company headquartered in my town called Clayton Homes. Rather than build homes on site, the firm builds them in sections, or modules, in one of its facilities. Construction can happen in less than a week. Once built, the modules are transported to the home site, where they’re attached to each other atop the home’s foundation.
If you visited one of these homes, you’d never know that the entire structure was assembled this way. Clayton uses the same quality of materials, and meets the same state and local building codes, as site-built homes.
You can think of target-date construction the same way: Many target-date funds are built from a handful of different components that are then joined together. For example, Vanguard Target Retirement 2065 (symbol: VLXVX) holds Vanguard’s Total Stock Market Index Fund (53.3%), Total International Stock Index Fund (36.8%), Total Bond Market Index Fund (6.8%) and Total International Bond Index Fund (3.1%).
Every provider builds its target-date funds a bit differently. Some use passive index funds, some use active funds and some use a blend. Stocks and bonds are the primary asset classes involved, but some target-date funds also dedicate a minor allocation to alternatives like real estate investment trusts and commodities. While each target-date fund is built with its own flavor, you won’t find any that are built with products that guarantee income or preservation of principal.
Glide path. A target-date fund’s investment mix changes automatically over time, often every five years. This is called the glide path. The purpose is to decrease fund volatility as the fundholder nears retirement. Some funds stop the glide path and keep the investment mix static at retirement, while others will change once or twice more.
Target-date funds are offered in series based on the estimated retirement year. Depending on when you want to retire, you could choose from a fund roster that includes a 2065 fund, 2060 fund, 2055 fund and so on. These are sometimes referred to as “vintages.”
Typically, the stock allocation decreases and the bond allocation increases as the fundholder moves down the glide path. For example, Vanguard Target Retirement 2025 (VTTVX) holds the same four funds as the 2065 fund, but with lower stock and higher bond allocations. It also has a 3% allocation to Vanguard’s Short-Term Inflation Protected Securities Index Fund.
The best part about the glide path is that it takes the investment decisions out of the hands of the fundholder. The years right before and right after retirement can be the most important in a person’s investing career. They can be fraught with worry about “not having enough.” By removing the allocation decisions, the glide path feature prevents fundholders from making emotional, ill-timed changes to their portfolio.
The bottom line: Target-date funds have numerous features that make them useful tools. It’s important, however, to be clear about what they are and aren’t designed to do. They provide portfolio growth during our accumulation years and risk management later on, but they don’t provide guaranteed income or guaranteed returns. Investors who want those features will need to look elsewhere.
This article originally appeared on HumbleDollar.com
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