How and why do investors use target date funds?

Understand why target date funds are particularly attractive

A target date fund is a type of investment fund that adjusts its asset allocation over time based on a specific target date. Target date funds are also referred to as lifecycle, dynamic or age-based funds.  Target date funds typically provide more exposure to growth assets, such as equities, in early years when risk capacity is higher, and become increasingly more conservative as time progresses with exposure switched progressively towards capital-preservation assets, such as bonds.  For example, a 2050 target date fund is likely to have a higher allocation to equities than a 2020 target date fund.

Usually investors select a target date fund to coincide with their expected retirement date or the date that their children may commence schooling if they are saving to pay for education costs.  Target date funds will have the target or expected retirement date in the fund name such as the Vanguard Target Retirement 2045.  Target date funds have been very popular in the United States with 401k plans (the US version of Australia’s self-managed superannuation fund).  In Australia they have grown in number and popularity following the introduction of the MySuper rules.  The reason for their popularity lies in their convenience and simplicity, which removes the requirement to involve a financial planner or investment adviser.  There are a vast array of different styles of target date funds – some use low cost index funds or exchange-traded funds to implement asset allocation, whilst others use more expensive actively-managed underlying funds.

Research suggests that age is by far the most important determinant in setting an investment strategy, therefore target date, or age-based funds are particularly attractive as default investment funds.  They are based on the simple premise that the younger the investor or the longer the time horizon, the greater the risk the investor can take to potentially increase returns.  As seen in the chart below, target date funds differ from risk-based funds such as balanced funds or growth funds, which maintain relatively static asset allocation and risk profile over time irrespective of the age or retirement date of the fund members.

The speed with which a target date fund de-risks the portfolio’s asset allocation is referred to as the "glide-path", using the analogy of an airplane coming in for a smooth landing to arrive at the target date with the appropriately low-risk asset allocation.  On the target date, target date funds are not liquidated, rather they usually just maintain their final asset allocation which may still include some exposure to growth assets such as shares in order to provide an inflation hedge for investors.

Whilst the key benefit of a target date funds is their set and forget (or autopilot) approach to investing for retirement without the need to manually change asset allocation at different age milestones, they are not without criticism.  For starters, different funds with the same target date may have very different asset allocations, risk profiles and glide paths, which makes it quite complex to compare target date funds.  Target date funds may also have different rebalancing approaches – some may adjust asset allocation frequently whereas others may only change asset allocation every five years.  The other problem is that they require or assume that an investor puts all their retirement assets in that one target date fund, which may not be the case.  Target date funds also suffer from path dependency, which means that investors need equities to perform more strongly during the early years of the target date fund when their exposure to equities is the greatest rather than in the later years when their exposure to equities has been reduced.

 
Allocation to Growth Assets
 

 

 

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