Individual investors and retirement fund managers alike are looking for best ways to balance the competing goals of portfolio diversification, de-risking of asset allocations, and securing retirement income. To that end, target date funds (TDFs) have become an increasingly popular way to provide a low-maintenance, self-adjusting investment option that automatically rebalances and de-risks the investment portfolio over time as an investor moves closer to retirement. According to a recent report by Boston College’s Center for Retirement Research, TDFs often invest in specialized assets, charge modest fees, and earn returns that are broadly in line with other mutual funds.
Given that most participants in defined contribution (DC) plans are not investment experts, TDFs offer a simplified savings option with no investment decision-making on the part of the member. Developed in mid-1990s, TDFs started gaining additional traction after being designated a Qualified Default Investment Alternative in 2006. As of last year TDFs accounted for roughly 18% of total DC assets (for the top public and private plans combined), while approximately 60% of new 401(k) participants held TDFs.
TDFs are generally comprised of mutual funds and provide a long-term investment strategy by pooling together assets of individual plan members that target retiring in a particular year (a retirement target date in 2035, for example). Aimed at accruing and then securing assets after the retirement, TDFs automatically shift the asset allocation from high yield investments (e.g., equities) in the very beginning to more conservative instruments (e.g., bonds) closer to the targeted retirement date.
The CRR report provides an interesting analysis of Morningstar data on over 220 TDFs between 2004 and 2012, investigating TDFs investment strategies, fee structures, and how they perform relative to their underlying funds and other mutual funds. Among CRR’s findings:
- TDFs mostly had relatively uniform asset allocations, with most of the funds for 2035 target dates holding 70% to 85% in equities in 2011.
- Meanwhile, contrary to a common belief that TDFs simply hold a mix of equities and bonds, CRR found that a typical TDF was investing in an average of 17 mutual funds.
- TDF holdings often include such specialized assets as real estate, commodities, and emerging market instruments.
- Diversification is clearly one of the TDF’s positive traits, allowing this structure to reduce both the risk profile of the portfolio, as well as exposure to market fluctuations over time as the employee ages.
- Furthermore, total TDF fees were just slightly higher than if one were building a comparable investment portfolio on their own.
- TDFs were also found to slightly underperform their benchmark indices, though their overall performance was nearly equivalent to other mutual funds.
TDFs build on attractive DC features such as stable, predictable contributions and full portability of assets, and their ability to secure retirement income is a good fit for employees who plan to make partial withdrawals throughout the span of their retirement years. TDFs particularly appeal to younger, more mobile workers below 30 that almost unanimously (97%) support TDFs, J.P.Morgan reports. Given that, it’s not surprising that TDFs are anticipated to reach 70% of DC plan assets over the next decade.
Overall, TDFs offer an attractive option for a wide range investors and have an important and increasing role to play in advancing the cause of retirement security.