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When Using a Target-Date Mutual Fund, Buyer Beware

Investing is arguably the most complicated and intimidating aspect of managing money. That’s one reason why target-date mutual funds have become so popular. Such funds, offered by many mutual fund companies, handle some of the most important investment tasks for you. They are now the default choice in many workplace retirement plans.

But is using a target-date fund the best way for you to invest? And if you’re using a target-date fund, are you using the right one? Let’s take a closer look.

A simple way to invest

The appeal of target-date funds is easy to understand.

All you have to do is choose a fund that contains as part of its name the year closest to the year of your intended retirement date. If you’re 30 years old and plan to retire when you’re 70, you’d choose a 2060 fund (they’re usually offered in five-year increments).

The fund’s asset allocation—that is, its mix of stocks and bonds—is designed with that target retirement date in mind. A 2025 fund, for example, would be relatively conservatively invested since it’s designed for someone who intends to retire in the year 2025. By contrast, a 2060 fund would be more aggressive.

That’s a core principle of asset allocation. The more time you have until your intended retirement, the more risk you can afford to take in a quest for a better return. The less time you have, the less risk you can afford to take.

Another key benefit of target-date funds is that they automatically adjust their asset allocation over time, becoming more conservative as their target date draws closer.

All target-date funds are not created equal

A major watch-out with target-date funds is that different fund companies may use very different asset allocations for funds designed for the same target retirement date. The companies simply have different philosophies. One may believe that a person who plans to retire in five years should still have 70% of their portfolio in stocks. Another may believe such a person should have 50% in stocks. Of course, these different portfolio designs lead to different outcomes.

The table below shows how three leading mutual fund companies’ 2010 funds performed in 2008, a year when the market fell by nearly 40%. As you can see, all suffered significant losses even though they were designed for people right on the cusp of retirement.

2008 Performance

Stock Market

-37.2%

Fidelity 2010 Fund

-25.3%

Vanguard 2010 Fund

-20.7%

T. Rowe Price 2010 Fund

-30.8%

By contrast, let’s take a closer look at how target-date funds performed in 2013, an especially strong year in the market. For this comparison, let’s look at funds that should have a very aggressive asset allocation—those designed for people who plan to retire around the year 2055.

The table below shows the performance of the same companies’ 2055 funds. While all three had good years, they also significantly under-performed the market.

2013 Performance

Stock Market

34.5%

Fidelity 2055 Fund

22.7%

Vanguard 2055 Fund

24.3%

T. Rowe Price 2055 Fund

25.9%

So, keep in mind that target-date funds may not provide the protection you assume during bear markets, nor are they designed to outperform during bull markets.

Finding the ideal target-date fund for you

If you’re going to use a target-date fund, be sure to take the following steps.

First, figure out your optimal asset allocation by completing an asset allocation questionnaire.

Then, compare your optimal asset allocation with the allocation used by the target-date fund you are using or considering.

For example, here are the current allocations used by the same three companies in their 2025 funds (just search on the name of the fund company and the target retirement date — “Vanguard 2025 fund,” for example—and then click on a tab that says “composition” or “portfolio.”)

Stocks

Bonds

Cash

Fidelity 2025

63%

32%

5%

Vanguard 2025

61%

39%

0%

T. Rowe Price 2025

64%

34%

2%

These three funds are fairly similar. Still, if you’re planning to retire in or around 2025, which one most closely matches your optimal asset allocation?

As another example, here are the current allocations used by the same companies for their 2060 funds.

Stocks

Bonds

Cash

Fidelity 2060

93%

6%

1%

Vanguard 2060

89%

11%

0%

T. Rowe Price 2060

87%

11%

2%

If you’re planning to retire in or around 2060, which one most closely matches your optimal asset allocation?

Lastly, if there is a difference between your optimal asset allocation and the one used by the fund you are currently invested in, there are two options.

First, if you have access to funds from various mutual fund companies, see if one of those companies offers a fund with your target retirement date that uses an allocation that matches or is close to your optimal asset allocation.

Second, if you are limited to funds from one company, consider using a fund with a different target date than the one closest to your intended retirement date. That may help you find a fund that uses an allocation that more closely matches your optimal asset allocation.

The bottom line on target-date funds

Target-date funds provide the benefits of setting the asset allocation for you based on your intended retirement date and then automatically changing that allocation as you near that date. Keep in mind, though, that all target-date funds are not same, so it’s important to know your optimal asset allocation and match it to a target-date fund that’s designed similarly.

Also keep in mind that target-date funds may not provide the downside protection you assumed during bear markets and are not designed to capture all of the upside in bull markets.

Do you use a target-date fund? How careful have you been to choose a fund that most closely mirrors your optimal asset allocation?

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2 Responses to When Using a Target-Date Mutual Fund, Buyer Beware

  1. Alan Siegel July 16, 2019 at 2:34 PM #

    Your article is a good explanation of how target date funds work and what they are. What the article does not address is how to determine the best asset allocation for an individual. Where do you get an asset allocation questionnaire?

    • Matt Bell July 17, 2019 at 10:08 AM #

      Actually, there is a link in the article, Alan. It’s under the sub-head, “Finding the ideal target-date fund for you.”

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