Target-date funds: enabling investors to focus on the hard work of saving for retirement

Anyone saving for retirement knows there are lots of distractions, from competing savings priorities to the always-fluctuating financial markets. Target-date funds (TDFs) take this difficult process and simplify it by managing the investment decisions over time, taking the agreed-upon retirement date and managing the accumulated funds.

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Target-date funds help you from getting too brave or too fearful

The hardest part of saving for retirement may be the act of saving itself, putting aside regular amounts when there may not be much left in the monthly budget. The process may be even more important than the investments chosen, because a large percentage gain on a small amount of principal could likely still be a small amount of money.

But financial markets have a way of distracting many investors from this essential activity. For example, as money builds, it’s natural to want it to build faster. Gravitating toward momentum at the wrong time could be an expensive mistake, because of the time it might take to recoup losses.

Academics and practitioners have also documented the tendency of many investors to sell their investments at market bottoms when things seem bleakest and to reinvest only after a recovery is well under way. Over time, these emotional reactions may take a big toll on a retirement account.

In the chart below, the orange line shows a hypothetical investor who bailed out of stocks near the bottom in early 2009 and invested in cash. The green line shows an investor going from stocks to bonds. The blue line reflects the benefits of staying in equities even when things looked bleakest. 

 

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By maintaining a diversified approach that is allocated to stocks in the early years, TDFs help investors weather the extremes of the markets, thereby hopefully preventing them from making the kind of knee-jerk decisions they could regret.

The other problem with emotional selling is having to be right twice: knowing when to get out and when to get back in. Returning to the market after selling is difficult, even for short-term traders. Imagine how much more challenging the process is for a long-term saver who has sold at the bottom only to see stocks rebound. The idea of selling in a volatile market and buying back once things have settled may be comforting, but it’s rarely good practice. TDFs seek to avoid this problem. In fact, they may benefit from market volatility through rebalancing, buying more of what has recently fallen.

Keeping you on track over time

TDFs can help with more than just emotional decision-making, thanks to something called a glide path. Over time, these funds automatically shift their investment mix, moving investors’ equity allocation gradually lower. A hypothetical TDF for new savers, with, say, 40 years until the target date, might have nearly 100% allocated to equities with a relatively tiny amount in fixed-income securities. Compare this with a fund only 5 years away from the target date. Such a fund would likely have closer to 50% each in stocks and bonds.

Investors can have their portfolios managed “to” or “through” a given target date. Managing “through” the target date will typically involve maintaining greater equity exposure after retirement. With life spans generally extending, this approach may make sense for many investors seeking to maintain purchasing power and growth while investing more conservatively. For a retiree, having to make these shifts in allocation is time-consuming and probably ill-suited to the investor’s desired lifestyle. 

Target-date funds are growing in popularity

Approximately $2 trillion are currently invested in TDFs.1  As of 2016, according to the Investment Company Institute (ICI), more than half of all 401(k) accounts held TDFs, up from less than 20% ten years earlier.2  They may help shield investors from some of the market’s extreme swings by virtue of their broad diversification while also automatically keeping the mix of investments age appropriate over time. The only thing left to do for an investor is the most important thing of all: save for retirement.

 

1 Morningstar, May 2020. 2 2020 Investment Company Fact Book, p. 175.