Updated: Dec 29, 2020
The What, Why, and How.
Most of you have probably come across "Target-Date" funds within your retirement plan's investment options. Although the name is pretty self-explanatory, this overview will explain how they work, the two different types, and their usefulness.
The Basics Target-date funds were created to help individuals effectively invest for retirement through a one-stop solution. The name of a target-date fund always includes a year, which, as you probably guessed, corresponds to an expected year of retirement (target-date funds may also be used when saving to put kids through college). For instance, the "Schwab Target 2060" fund uses 2060 as the expected year of retirement for those who are invested in the fund. These funds start out aggressive (the Schwab 2060 fund is currently over 90% allocated to stocks) and shift the allocation towards a more conservative positioning as the target year approaches. This "glide path" is in place to take the burden of asset allocation out of the hands of the individual so that they do not have to worry about changing their asset mix as they near retirement. Fund families establish these fund series in increments of 5 years in order to best cover all of the possible retirement horizons of the working population. However, depending on the fund family (i.e. Vanguard, Schwab, Fidelity, etc.), the investment process may differ in relation to the target year. Funds can either be "To" funds or "Through" funds.
"To" Funds vs. "Through" Funds "To" Funds: This type of target-date fund reaches its "final" allocation when it hits the designated target year. For example, the final allocation might be 25% stocks and 75% bonds/cash, and, after the fund reaches the target year, the fund will be allocated in the same manner from there on. "Through" Funds: In contrast to "To" funds, "Through" funds do not reach their final allocation until after the target year. In the case of Charles Schwab's target-date funds, the final allocation is reached 20 years after the target year. This allows for a "retirement period" after the target year is reached that includes a higher allocation to stocks than you would find in corresponding "To" funds. (The Schwab 2020 Fund is currently about 40% allocated to stocks) Because of this difference, it is important to know which type of fund you are invested in/which type is offered through your plan. In 2008, many people were surprised when their 2010 target-date funds still suffered large swings even though they were only 2 years from their target retirement year. While most of those reading this are nowhere near their potential target-date, this example highlights the importance of knowing how these funds work, especially if you are using one, so that you can know what to expect.
Are Target-Date Funds an Effective Tool? Target-date funds provide some clear benefits to the individual investor; they reduce the complexity of investing down to the selection of a single fund, they automate the asset allocation process as your asset mix shifts along with your age, and they provide a good starting point for inexperienced investors who are starting to save for retirement. Along with these benefits, there are some drawbacks. Mainly, the one-size-fits-all structure can't take into account each individuals unique situation. Investors may need to take more or less risk than is offered by their corresponding target-date fund in order to meet their goals in retirement and when such situations arise, target-date funds may not be the best option for constructing your portfolio. Additionally, investors may not know exactly how their target-date fund is serving them and if that matches their needs. For that reason, it is important to know how your plan's target-date offering works and invests. Ultimately, target-date funds are a simple and effective tool for getting individuals on the right path to saving for retirement. However, as an individual's financial situation becomes more complex and their goals/needs change, the one-size-fits-all structure may begin to lose its effectiveness.