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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:
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 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).
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 Fund | 38% | 47% | 55% |
Vanguard Total Bond Market II Index Fund | 26% | 16% | 7% |
Vanguard Total International Stock Index Fund | 25% | 31% | 35% |
Vanguard Total International Bond Index Fund | 11% | 6% | 3% |
100% | 100% | 100% |
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!
Begin with the understanding that each mutual fund company is different in their approach. Here are a few items to keep in mind:
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