What is... | July 13, 2015

What is a target date fund?

Do you have a date in mind for when you want to retire? This piece of information is key if you want to use a target date fund – one way to boost pension savings over time. Target date funds offer a controlled “glide path” that aims to reduce risk.

Target date funds first came out about 20 years ago. They may be offered by mutual funds, banks, trust companies or insurance companies – as part of a defined contribution pension plan or a separate investment for individuals saving for retirement.

Look before you leap
As always, is important to check the fees, pensions laws and tax allowances before investing; these vary and can make a big difference to a potential return. Target date funds have become more popular recently – perhaps partly because of ageing populations and uncertainty about pension arrangements in many countries.

Target date funds are a special kind of lifecycle investing. Unlike with standard lifecycle investments, fund managers can alter the asset mix along the glide path. This additional flexibility is a key feature.

Is my path to 2050 the same as yours?
One of the benefits of target date funds is that once enrolled, investors don’t need to keep a constant watch on their portfolio strategy. However, Investopedia highlights limitations: funds may not take into account that one investor wanting to retire in 2050 might have a different risk tolerance than another investor wanting to retire in the same year.

Moreover, because target date funds are designed to try to reduce risk in the final years before retirement, the ultimate pension nest egg may be smaller than if more risk was taken. This is explored in research.

Improving cruise control
A target date fund may mix and match different types of assets – such as shares, bonds, gold or other commodities, or cash. The idea is to balance changing levels of risk against stable yet modest returns for the amount invested. Each target date fund will have a typical “glide path” or trajectory, aimed at reducing the risk yet still producing a desired return.

Specific funds can vary widely in terms of risk, however, even when they have the same "target" retirement year, as this paper warns.

Target dynamics
Target date funds typically become increasingly conservative over time as the investor’s retirement gets closer. A popular strategy is moving more shares to bonds and cash as the years go by.

“Perhaps the best known application of this strategy is the so-called ‘age in bonds’ rule, which suggests that the proportion of bonds in an individual’s portfolio should be equal to his age, and that of stocks equal to 100 minus his age,” this European Financial Review article notes. “Thus, an individual should have a 70-30 stock-bond allocation when he is 30 and a 35-65 allocation when he is 65.”

Reducing risk?
With target date funds the risk may be reduced, but the investor loses a chance to benefit from long-term potential gains (and losses) that happen in the share market. And some question whether the ability to control what happens with investments is little more than an illusion.

Professionals in any field may believe their more sophisticated understanding of the market will protect them from error. Because of this, they may more easily fall prey to overconfidence bias and base rate neglect. An eZonomics poll confirms that many people believe they know “more than most people” about managing money.

Protection in turbulent times
Planning for retirement is an important part of healthy personal finances for many people. Target date funds may help some people do this. Individuals must decide how much risk to accept – no matter who ultimately manages an investment.

This article offers one way of working out an asset allocation strategy. However, remember that diversifying assets will typically help spread risk.


eZonomics team
.(JavaScript must be enabled to view this email address)