September 21, 2018 -- "I just put all my money in this target date retirement fund." I hear this all the time when the topic of 401(k) investments comes up. But what does a target date fund actually do? When I quiz those same folks, I usually get the following two responses:

  • You just pick the fund based on the year you're going to retire.
  • The fund gets more conservative the closer you get to retirement.

Then there's a slight pause. At this point, the rest of the conversation goes something like this:

Me: What's actually in that fund?
Answer: Hmm. Not sure. Stocks and bonds?

Close, but not exactly.

A "fund-of-funds"

A target date fund is usually a "fund-of-funds". Unlike a typical mutual fund which invests directly in individual stocks and bonds, a target date fund invests in other mutual funds. For example, while an S&P 500 Index fund holds shares of the individual stocks that make up the S&P 500 Index, a target date fund might hold shares of the S&P 500 Index fund itself, rather than the individual stocks. Likewise, instead of owning a portfolio of individual bonds, a target date fund would typically invest in a separate bond mutual fund (which already owns an assortment of bonds).

A changing investment mix

The second feature of target date funds is that they change their asset allocations over time. Just as you might consider changing your investments to become more conservative as you get closer to retirement, a target date fund's goal is to do this for you. For example, let's take a look at the current holdings in three of Vanguard's target date funds*.

Target Retirement
2025 Fund
Target Retirement
2035 Fund
Target Retirement
2045 Fund
Vanguard Total Stock Market Index Fund38%47%55%
Vanguard Total Bond Market II Index Fund26%16%7%
Vanguard Total International Stock Index Fund25%31%35%
Vanguard Total International Bond Index Fund11%6%3%

What do you notice about these four funds?

  • They're fairly simple: each only holds four investments
  • Even though they only hold four investments, they're well-diversified, since each of those investments is a different index fund
  • These funds hold the same four investments
  • The funds become more conservative (fewer stocks, more bonds) the closer they get to the target retirement date, simply by shifting the allocation between the underlying funds.

Also, each of these funds will change its investment mix as time goes by. For example, ten years from now, the 2035 fund will look closer to today's 2025 fund, and the 2045 fund will look more like the current 2035 fund. So by comparing different target date funds within the same mutual fund company, you can get an idea what your current target date fund will look like in the future!

Before you invest in a target date fund . . .

Begin with the understanding that each mutual fund company is different in their approach.  Here are a few items to keep in mind:

  • Two funds with the same target date can have very different ratios of stocks to bonds, depending on the specific mutual fund company that manages them.
  • Two funds with the same target date – but offered by different investment companies – could also hold significantly different types of funds. The Vanguard target date funds in the example above each held four broad index funds. But the same target date funds from another company could own 10, 20, or more different funds, including specialized funds that invest in specific industries or countries.
  • Fees can also vary significantly among target date funds offered by different companies.

And obviously, if you own other investments, it's important to evaluate how a target date fund fits in with the big picture. So although target date funds can offer many benefits and help simplify your investing, you should always consider the above factors before making a decision to invest in one.

With offices in both Portland and Lake Oswego, Delap LLP has been one of Oregon's largest local tax, audit, and consulting accounting firms for 85 years. Call your Delap advisor at 503-687-4118 to discuss 401(k) Plan audits or other accounting challenges you're facing.

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* Current as of August 31, 2018

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