Target Date Funds (TDF’s) are supposed to make investing easier and better for the many investors who want the simplest-possible solution when investing for retirement. Each fund family that creates a set of Target Date Funds must make a set of assumptions about investor risk tolerance, as well as making choices about the range of asset classes to include. While all of these funds are designed in order to provide a one-fund solution to investing that evolves as an investor ages, there are substantial differences between these funds.
Key Questions to Ask
A recent article in the Wall St. Journal summarized five important questions that any investor should ask before they select a Target Date Fund:
- What is the glide path?
- Is the fund designed to go ‘to’ or ‘through’ retirement?
- What is the expense ratio?
- Does the fund employ strategic asset allocation, tactical asset allocation, or both?
- Is the fund well diversified?
I agree that these are all relevant questions. The glide path, the rate at which exposure to equities decreases with age, is a key component of the design of a target date fund. The glide path is the primary factor in determining how risky a fund is at each stage in an investor’s life. Deciding whether a glide path is right for you is largely determined by question (2). If your goal is to cash out at retirement and purchase an annuity, a more conservative glide path may make the most sense. If you plan to remain invested through retirement and draw income, a more equity-oriented glide path will generally be better. Expenses are, of course, crucial. Low expenses are a ‘must’ for long-term investors.
Practical and Effective Solutions
Back in March 2008, I wrote an article about target date strategies. At the time, I was designing a series of Target Date Folios for Folio Investing and our analysis of existing Target Date Funds suggested that many of them were not well diversified. That in turn meant that they were not providing as much return as possible at each level of risk.
One way I got around that was to design the Folios using ETFs, which allowed for low-cost inclusion of ‘alternative’ asset classes such as commodities.
We have recently passed the 2 1/2 year anniversary of the Target Date Folios. This has been a tumultuous period, encompassing a massive market decline followed by a substantial recovery. We have analyzed the performance of the Folios compared to the equivalent funds from the three fund families that have controlled the vast majority of Target Date assets for the last 2.5 years. While 2-3 years cannot be considered conclusive, the results are consistent with our original analysis.
This supports the importance of the WSJ’s last item on the list: diversification. The premise of Target Date Funds is that experts create well-diversified funds, that capture the benefits of combining key asset classes.
The Future for Target Date Investing
Hewitt’s annual survey of how investors are doing with their savings and investing in 401(k) plans finds that pre-built portfolios such as target date funds have shown enormous growth. Furthermore, a joint study by Hewitt and FinancialEngines.com has found that investors using target date funds and other expert-based guidance have out-performed those who do not use such resources. This is all generally good news.
Target Date strategies are here to stay, but the weaknesses in the first generation of target date funds have shown the way to improved solutions. I hope that the Target Date Folios will inform the evolution of Target Date investing.