Target date funds, examined

Target date funds hold the majority of new contributions in many workplace plans, largely because they are the default. They are a good default and they are not interchangeable.

What they do

A target date fund holds a diversified mix of assets and shifts that mix toward more conservative holdings as the target year approaches.

The path of that shift is called the glide path, and it is the defining characteristic of the product.

The appeal is genuine. A single holding provides diversification, automatic rebalancing and an allocation appropriate to the time horizon, with no decisions required.

Evidence on investor behaviour supports this. Target date fund holders trade less, are less likely to sell during declines, and have generally achieved returns closer to their funds' returns than investors in other fund types.

That behavioural benefit is probably worth more than any allocation refinement.

Where they differ

Equity allocation at the target date. Two funds with the same target year from different providers can hold substantially different equity percentages — differences of twenty percentage points or more are documented.

That is not a minor variation. It represents a materially different risk profile for someone retiring in the same year.

To or through. The most important structural difference.

A fund designed to reach its most conservative allocation at the target date is a "to" fund. One that continues reducing equity for years or decades afterwards is a "through" fund.

Through funds typically hold more equity at the target date, on the reasoning that retirement lasts decades and inflation is the larger risk.

Neither approach is wrong, and someone who assumes their fund is one type when it is the other may be holding considerably more or less risk than intended at the moment it matters most.

Cost. Expense ratios across target date funds vary by an order of magnitude.

Index-based versions from low-cost providers charge a small fraction of what some actively managed versions charge, and the difference compounds across decades.

Underlying holdings. Some hold only broad index funds; others include actively managed sleeves, alternatives, or allocations to specific sectors.

The criticisms

Age is a crude proxy. Two people retiring in the same year can have entirely different situations — different other income, different assets, different risk capacity.

A fund keyed to a date cannot account for any of that.

Taxable accounts. Target date funds are inefficient in taxable accounts, because rebalancing inside the fund can generate distributions and because the fixed income allocation generates ordinary income.

They are best used in tax-advantaged accounts.

Combining them with other holdings defeats the purpose. Someone holding a target date fund plus several individual funds no longer has the allocation the target date fund was designed to provide.

If used, it should generally be the whole account.

Using them well

Check what it actually holds now, rather than assuming.

Consider a different year than your own. Someone who wants more equity can choose a later target date; someone who wants less can choose an earlier one.

This is a legitimate and simple way to adjust risk within a limited fund menu.

Compare the cost to building the same allocation from index funds available in the plan, which is frequently cheaper and requires manual rebalancing.

Check the glide path type before retirement, since it determines your allocation at the point of maximum vulnerability.

The alternative

For those willing to do slightly more.

Two or three broad index funds — total market equity, international equity, total bond — held in a chosen proportion and rebalanced annually.

This is generally cheaper, entirely transparent, and works in taxable accounts. It requires deciding the allocation and adjusting it over time, which is the work the target date fund does for you.

Either approach is defensible. Both are considerably better than an uninvested balance or a menu of expensive actively managed funds selected at random.

General information only, not financial advice. Fund characteristics vary — read the prospectus and consult a qualified adviser about your own situation.