5 things you should know about target date funds

Piggy bank in a vice.

Saving for retirement is never easy, but target date funds can help eliminate some of the guesswork in choosing your 401(k) plan investments.

Rather than picking stocks and bonds on your own to create a diversified portfolio, you select a single fund designed to have the right combination of assets based on when you plan to retire — your "target date."

The further out your target date, the more risk you'll be exposed to.

Younger investors will pick a target date fund that has a mix of stocks and bonds with the most potential to increase in value.

Of course, this mix also is more volatile and liable to lose money in a down market. Someone closer to retirement might want a more conservative mix.

With a target date fund, your investment manager does that rebalancing work for you.

"The asset allocation, rebalancing and investment selection decisions are often the most intimidating for a novice investor," says Kent Anderson, a chartered financial analyst and wealth management investment officer with Country Financial in Bloomington, Ill. "Target date funds take away these concerns and put these critical decisions on autopilot."

It's a set-it-and-forget-it approach to investing, and it's becoming an increasingly popular way to save for retirement.

Total target date fund assets have tripled since 2008, to $481 billion, according to the Investment Company Institute, the national association of U.S. investment companies.

But their popularity doesn't mean they are without risk. Here are 5 things you need to know before deciding whether this investment option is right for you.

Fact 1. Your investment choices are limited.

Average Expense Ratios Fall for Target Date Funds

Source: Investment Company Institute

Year Ratio
2008 0.67%
2009 0.67%
2010 0.65%
2011 0.61%
2012 0.58%

Within a 401(k) plan, you might be offered target date funds from a single company. For example, you may be limited to Fidelity’s funds if Fidelity is your company’s 401(k) plan provider.

"This presents a conflict of interest between the mutual fund companies and their fund investors," says David Nanigian, associate professor of investments at the Richard D. Irwin Graduate School of The American College of Financial Services in Bryn Mawr, Pa. "These target date funds often invest not only in funds with high fees but also in those that perform poorly."

If you have no choice, you cannot shop for a fund with the lowest fees. And even if the fees are reasonable, they may be higher than what you'd pay by investing in the fund's individual components on your own.

Essentially, you’re paying a premium to have the brokerage handle fund selection and portfolio rebalancing.

The average target date fund had a 0.58% expense ratio in 2012, according to an Investment Company Institute report.

The average index fund, which buys shares in all the companies represented in a widely watched measure or index of how the stock market is performing, had an expense ratio of 0.12%, according to the ICI report.

Either average is still acceptable, as we recommend you consider funds that charge no more than 1%.

Fact 2. Other options may perform better.

Target date funds underperform balanced funds — which also have an investment mix, but don't alter that mix over time — by about 0.5% after fees are deducted, according to Vallapuzha Sandhya, a research associate at Financial Engines, an independent investment adviser.

One explanation: Brokerages funnel investors’ money into the brokerage’s own funds to increase revenues, not because those funds are great performers.

In other words, you won’t find a Vanguard mutual fund in your Fidelity target date fund, even if the Vanguard fund has the best performance and the lowest fees. You’ll get nothing but Fidelity funds.

Fact 3. Target date funds don't guarantee a return.

Even in an ideal world where every target date fund was composed with investors’ best interests in mind, you still risk losing principal.

Many investors don’t understand that.

In a survey commissioned by the Securities and Exchange Commission, 30% of respondents indicated they think target date funds provide guaranteed income, while 15% said it depended on the fund and 20% said they didn't know.

The truth is, target date funds "are exposed to the same types of market risks as their underlying investments," says Peter Fisher, an accredited investment fiduciary and managing partner of Human Investing in Lake Oswego, Ore.

change spilling out of a jar7 rules for a successful 401(k) retirement account: Here's how to make all of the right decisions so that you'll save more, invest wisely and take full advantage of all the tax breaks available to you. We can't guarantee that you'll be able to build the nest egg you need for the retirement you want. But we can guarantee this: Some savings will always be better than no savings.

Fact 4. The fund may take too much — or too little — risk.

When evaluating a target date fund, you need to understand its glide path, or how the fund’s asset allocation is supposed to change over your lifetime.

Here’s an example of how a fund’s glide path works:

If you choose the Fidelity Freedom 2055 fund because you’re just entering the work force and don’t expect to retire for 40 years, your initial asset allocation will be about 10% bond funds, 25% international stock funds and 65% domestic stock funds.

Over the next four decades, Fidelity will gradually shift your asset allocation to include more bonds and fewer stocks.

When you reach retirement in 2055, you’ll hold about 40% domestic stock funds, 10% international stock funds, 40% bond funds and 10% short-term bond and money market funds.

That allocation continues to become more conservative during your retirement years.

Because the glide path changes the fund’s asset allocation, the fund may end up selling at lows and buying at highs. Investors are then less likely to recoup their losses than if they held the same investments outside of a target fund and waited to sell until the market improved.

Keep in mind, you have the power to adjust your own risk by investing in a fund outside your own retirement timeline. If you want more potential for gains, invest in a fund with a target date further out; for less risk, invest in a fund with a closer target date.

Fact 5. Target date funds still may be your best option.

Even with their downside, target date funds are a solid choice for many 401(k) investors.

“Investors who use them properly are likely to outperform their results if they tried to pick funds on their own. They take a fair amount of research up front but can keep a novice investor from making mistakes in the long run,” Anderson says.

If you want to invest in a target date fund, experts recommend using a research tool like Morningstar to examine different funds. To get to the target date funds on its website, under the “Funds” tab, click on “Performance,” then on “Fund Category Returns.”

Click on a target date fund category, then on an individual target date fund, to see how its performance compares to Morningstar's benchmark and to similar funds. Look for a fund that matches or beats these standards.

Also look for low expense ratios (the closer to zero, the better) and an asset allocation that matches your risk tolerance.

Another research source is U.S. News’ Target Date Mutual Fund Rankings.