What You Need to Know Before Choosing a Target Date Fund in a 401(k)

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Looking for a one-stop-shop when it comes to 401(k) plans? Target Date Funds (TDFs) offer just that and have become all the rage with 401(k)s: Assets have ballooned from $71 billion in 2007 to $374 billion at the end of 2011. The folks who run retirement plans expect TDF assets to continue to balloon in the coming years as more and more employees choose to offload much of the retirement planning work.

The simplicity of a TDF is indeed alluring. Rather than having to take on the job of asset-allocator-in-chief, which typically entails having to pick and choose among a dozen or more stock and bond funds offered in a retirement plan, a TDF is a one-and-done decision. Finger the TDF with the year that corresponds to when you expect to retire and your work is done. The TDF handles all the asset allocation decisions and as a nice bonus assume periodic rebalancing duties as well.

But the sublime simplicity of choosing a TDF comes with a huge knowledge trap. If you don’t really understand the mechanics of how your TDF works you are potentially setting yourself up for a world of financial hurt come retirement. The problem is that there’s no single TDF playbook that all retirement plan providers must follow. Let’s just say strategies are pretty much all over the map. Moreover, TDF investors aren’t exactly up to speed on TDF basics.

Indeed, a recent survey sponsored by the Securities and Exchange Commission (SEC) shows that many individual investors are woefully uninformed about how TDFs work. Here’s a primer on what you’re not likely to see in the marketing brochures:

  • There’s no guaranteed income in retirement. Just 36 percent of respondents in the SEC survey correctly understand that investing in a TDF does not guarantee you will have a guaranteed income stream come retirement. All a TDF does is invest your money following a rational asset-allocation strategy. That strategy will include stocks and bonds and maybe cash. Some TDFs also invest in alternative asset classes such as real estate. There is no guarantee of exactly what the return on those portfolios will be. A TDF guarantees nothing. FWIW, the real key to having enough income in retirement depends more on how much you choose to contribute to your retirement accounts (and getting an early start), not how the money is invested.
  • The date of a TDF typically has no impact on the fund’s mix of stocks and bonds. Nearly one-third of respondents think that the date of a TDF is the year in which the portfolio will be ratcheted to its most conservative mix of stocks and bonds. That’s not necessarily true. The year of your TDF is merely the year the plan figures you will retire or at least stop making new contributions to your account. Most TDFs will continue to adjust your asset allocation well past the target retirement date.
  • What happens to your mix of stocks and bonds after you hit your target date depends on your TDF. Every TDF provider has its own strategy for the proper asset allocation at given ages, and how that mix will change over time. This is what is known as a glide path. Some (though not many) TDFs have a glide path that stops gliding right at the target retirement date, while most continue to adjust the stock-bond-cash mix for at least a decade past the retirement date. In the SEC survey, when asked whether a TDF’s glide path stops gliding at the target date, and stays at a fixed allocation, just 15 percent of respondents correctly answered “it depends.”
  • Your TDF and your BFF’s TDF at another company can be wildly different. A hypothetical will help explain this: Let’s say you’re at your college reunion, catching up with your classmates. Somehow the conversation winds around to retirement planning (hopefully your reunion isn’t this lame, but stick with me for the sake of this example) and it turns out that a bunch of you are relying on the TDF offered by your respective employer’s plans. Even though you’re the same age, and even assuming you’ve all chosen the same retirement date, the underlying portfolios in your TDFs might look very different.

Last year, Ibbotson, a subsidiary of Morningstar took a look at how TDFs from different fund companies invest in stocks for 50-year olds. The TDFs run by American Century had an average stock allocation for a 50-year old TDF participant of 59 percent. Fidelity and Vanguard were right around 65 percent. T. Rowe Price had 77 percent in stocks, on average. And the MFS Lifetime TDF had an average of 73.5 percent invested in stocks for its 50-year old participants.  Needless to say, that’s going to produce some divergent experiences in bull and bear markets. Yet in the SEC survey less than 10 percent of respondents understand that no two TDFs (for the same age) are created the same.

Choosing the TDF option in your 401(k) or 403(b) can be a terrific move. But that doesn’t mean you can afford to tune out completely. You still need to make sure that you understand exactly how your specific TDF operates, and that you are comfortable with its strategy.

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Carla Fried

Carla Fried is a freelance journalist who has covered just about every nook and cranny of personal finance for media including Money Magazine, The New York Times, and CBS MoneyWatch.com. Prior to launching her own reporting and writing business in 2002 she was a senior writer at Money and the managing editor of Quicken.com.

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