What's a target-date fund and how does it work?

Target-date funds are the default investment product for many 401(k) plans for good reason: They offer a diversified portfolio that considers an investor’s age and expected retirement date, gradually adjusting its asset allocation as that retirement date approaches. 

What's a target-date fund and how does it work?

Target-date funds are the asset management industry’s closest thing to a one-size-fits-all product for a broad cross section of retirement savers, providing investors with the means to grow their savings during their working years while managing risk and preserving capital in the years leading up to retirement.

Although their origins can be traced back to the 1990s, target-date funds were popularized by the 2006 Pension Protection Act. As part of the Act, they were recognized as qualified default investment alternatives for 401(k) plans with an automatic enrollment feature. This means that employees who are automatically enrolled in their 401(k) plans without specifying how they want their money invested will often find themselves invested in a target-date fund.

Target-date funds have since gone from strength to strength, blazing through the $1 trillion in assets milestone in 2017 and reaching $1.11 trillion by the end of the year—this is up from $880 billion in 2016 and a more than sevenfold increase over the course of a decade.1

U.S. target-date mutual funds in billions, 2008-2017

The glide path: the secret to a smooth ride to retirement

As the name suggests, target-date funds are designed with a specific retirement date in mind, often decades into the future. Over the duration of a fund’s life, the portfolio manager will adjust the underlying mix of assets with a goal of maximizing returns in the early years and minimizing risk the closer the fund gets to its target date. This gradual shift from capital growth to capital preservation is commonly referred to as the glide path.

The glide path is central to the effectiveness of a target-date fund. Let’s take as an example a 22-year-old office worker who plans to retire at age 64. With some simple arithmetic, a target-date 2060 fund would be most suited to her retirement plans. However, every investor has a unique set of circumstances, and a financial advisor may be helpful in providing guidance about how to address any specific needs regarding risk tolerance.

In the short to medium term, the portfolio manager overseeing the fund will likely invest as much as 80% or more of its assets in equities. This not only enhances the value of our office worker’s savings in those early years, but also considers her lengthy investment horizon; with some 40 years to go until she reaches her expected retirement date, our saver probably has enough time to make up any losses resulting from an upset in the stock market. As she moves closer to her 2060 target date, the portfolio manager will rebalance the asset mix in her fund, reducing the allocation to equities in favor of more defensive assets such as bonds and cash.

While asset mixes vary from one provider to another, a typical glide path provides around 70% to 80% equity exposure in the early years and somewhere between 50% and 65% at 10 years out. By the time they reach their target date, most glide paths offer equity allocations of around 40% to 55%.

At this point, some glide paths continue through retirement, further reducing equity exposure during the subsequent 10 years. Others essentially stop once they reach their target date and the asset mix remains static. 

How equity allocation changes in one example of a glide path

Things to consider

Target-date funds tend to be regarded as a set-it-and-forget-it investment: Continue making regular contributions, and the rest will take care of itself. While these products do require very little maintenance on the investor’s part, as with any investment it pays to do your research upfront and monitor performance on an ongoing basis.  

It’s important to note that target-date funds offer no guarantees over future returns. What they can provide, however, is an age-appropriate diversified portfolio that seeks to strike the right balance between maximizing growth potential and helping to mitigate risk.

Cost is another important consideration and has become just as big a talking point in the world of target-date funds as it has elsewhere in the asset management industry. Common sense suggests that lower costs allow investors to retain more of their investment gains, but it’s important to look beyond the price tag and consider the investment strategy and capabilities of the provider to accurately determine the appropriateness of the fees.

As a rule of thumb, investors who hold passive strategies should generally expect to pay less, whereas active management often comes with a higher cost. Some target-date funds, such as John Hancock Multimanager Lifetime Portfolios, offer a combination of active and passive investments, which can help reduce the impact of expenses on portfolio returns while retaining many of the benefits of active management. 

A road map to retirement saving

Target-date funds help simplify the process of investing for retirement, doing away with the need for an investor to personally build and maintain a portfolio of assets over the course of decades. By considering an investor’s age and expected retirement date, they provide a diversified portfolio that encourages growth when suitable but helps dial down risk when it’s most important—leading up to and in retirement.

Despite their reputation as a one-size-fits-all product, however, target-date funds can vary in their approach to risk, glide path length, and costs. By understanding these differences, investors can choose which approach is best suited to their needs.

Want to find out more? Check out our retirement planning page and learn about investing in target-date funds

1  2018 Target-Date Fund Landscape, Morningstar, May 7, 2018.