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It’s Time to Look Under the Hood of Your Target-Date Fund

April 26, 2018
Investing, Investments
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Is your target-date fund the right one for you?

It’s a question worth asking, especially as the markets move from a steady upward trajectory to a zigzag line. Target-date funds — the foundation of many 401(k) plans for their easy, hands-off approach — are put through their paces during market volatility.

Being hands-off may be well and good when the market is going strong. But investors are often spooked when it’s not, which can lead to panic selling, locking in losses.

That makes now a good time to ensure you’re comfortable with the level of risk you’re taking, including within any target-date fund in your portfolio. Even funds that are targeted to the same retirement year will differ in investment allocation and fees, so it’s worth your while to examine what yours is made of.

How target-date funds work

Target-date funds are mutual funds designed to align with when the fund’s investors plan to retire. To that end, they’re invested with a year in mind and automatically rebalanced to take more risk early on and less risk as that date approaches. (You can read more here about how target-date funds work.)

A 30-something investor might choose a 2050 target date fund, for example, which would currently be heavily invested in stocks — and could be heavily rattled by short-term market fluctuations. Just how heavily depends on the fund itself — the investment allocation even of target-date funds tagged with the same year can vary by 10% or more, as the chart below illustrates.

The trouble with hands-off

Many people in target-date funds don’t know how they’re invested or how much risk they’re taking, says Jeff Weber, certified financial planner and wealth advisor at Titus Wealth Management in Larkspur, California. That’s largely thanks to auto-enrollment programs that opt workers into a 401(k) and often use an appropriate target-date fund as the default option.

“You want to make sure that whatever fund you’re choosing is going to be appropriate from a risk tolerance standpoint,” Weber says.

That’s not to say that short-term market volatility should dictate your long-term investment decisions — in a stock market that averages 10% annual returns, dips are mere blips and generally don’t require a change in your investment strategy. But if you can’t handle the heat of a fund tipped aggressively toward stocks, turning down the fire is a better option than pulling out completely.

Look at the fund’s portfolio

Mutual funds are like a basket of investments; the idea is that investors can purchase many holdings in a single transaction. A target-date fund is typically set up as a “fund of funds,” or a mutual fund that holds other funds. Meta, but efficient.

To find out what’s inside your fund, you’ll want to look at its prospectus, or at the fund’s information page on your 401(k) or other account provider’s website. You can get as deep as you want here: You can look at the overall allocation of assets between stocks, bonds and cash, or you can delve into each of those categories for the list of the specific funds and assets that make up each bucket. At the very least, you want to make sure that the proportion of stocks to bonds is where you’d like it to be. (For more on how to figure out what proportion is right for you, read our deeper dive on asset allocation.)

Ideally, this is at least an annual exercise, Weber says. “These funds will make adjustments annually, adjusting down their equity position a point or two in reduced exposure as the fund gets closer to the target date.” Make sure you like any adjustments you see.

Pay attention to fees

There’s a lot you can’t control when it comes to investing — namely, market swings. One thing you can control, at least to some extent, is fees.

These target-date funds all provide a similar service, but the cost of that service can vary widely, even within a single fund provider. Schwab, for instance, offers target index funds — which utilize passive investments — and target funds, which also include actively managed mutual funds. The difference perhaps shows up best in fees: The Schwab Target 2050 Index Fund carries a net expense ratio of just 0.08%, compared with the Schwab Target 2050 Fund, which costs 0.73%.

A fund’s prospectus or information page will outline its expense ratio, or annual cost.

Figure out a strategy for doing better

The trouble is that many 401(k) plans offer target-date funds from a single fund provider; you may have only one option for the year nearest your projected retirement date. If that option doesn’t align with your appetite for risk — or for fees — you have a few choices.

The easiest solution is to select a different date — an earlier one, if you want to take less risk, or a later one if you want to take more. Yes, the dates are supposed to track to your retirement age, but there’s no one checking IDs at the door of the target-date fund club. Someone who finds a 2050 fund too vanilla can easily opt into a 2055 or 2060 fund instead.

If that doesn’t feel like a viable option, or you’re uncomfortable mingling outside your age group, you can either build your own portfolio out of other funds within your 401(k) plan, or contribute enough to earn your employer match and then take additional contributions for the year to an IRA.

» Learn more: What is an IRA?  

An IRA offers the tax advantages of a 401(k) with a wider fund selection and, consequently, more control over fees. You can even open an IRA at a robo-advisor, which is a service that builds and manages a portfolio of low-cost funds for you.

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