Target Date Funds: What The Year On The Label Buys

My first 401k put me into a target date fund by default and I left it there for six years without once opening the fund page. When I finally did, I found four funds nested inside it and an expense ratio I had never seen.

0.61 per cent.

The fund was doing precisely what it said on the label. I had simply never read the label, which is the normal experience with a default.

What the year on the label means

A target date fund is a fund that holds other funds, typically a handful of broad stock and bond index funds, and gradually shifts the mix from stocks toward bonds as the year on the label approaches. The year is meant to be roughly when you stop working.

The schedule of that shift is called the glide path, and every fund publishes its own. It is the single most important thing about the product and the thing almost nobody looks up.

At 25 a typical path sits around 90 per cent stocks. By 65 it is closer to half and half. Nothing in that schedule is tied to you personally except the single number on the label.

What it buys

Three things, and they are worth naming individually rather than as a package.

Diversification you would otherwise have to assemble yourself out of four or five separate funds. Rebalancing, which happens automatically and which almost nobody does by hand. And one decision made once, rather than a decision you renegotiate with yourself every January.

The month the market drops 18 per cent, the fund quietly sells bonds and buys stocks because the ratio has slipped away from the target. You do not have to notice it, decide anything, or feel brave.

That is the actual product. The asset allocation is available to anybody for free.

What it costs

An expense ratio is the slice the fund takes each year, deducted from the fund's value whether it goes up or down. It is quoted as a percentage and it never appears as a line on your statement, which is why it goes unnoticed for six years at a time.

0.60 per cent on a $200,000 balance is $1,200 a year. 0.10 per cent on the same balance is $200. Neither shows up as a withdrawal anywhere you would look.

The long version is worse. Put $500 a month in for thirty years and assume 7 per cent a year before fees. At 0.10 per cent you finish with roughly $598,000. At 0.60 per cent you finish with roughly $542,000.

Fifty six thousand dollars, for a rebalance that takes a competent adult about eleven minutes a year.

The two fund alternative

The same job, built by hand. One broad stock index fund and one broad bond index fund, held in whatever ratio you choose, rebalanced once a year by selling a slice of whichever has grown and buying the other.

What you give up is real. The rebalance only happens when you remember to do it. The glide path becomes you deciding to hold slightly more bonds every few years, which is a decision you will postpone. And you have to pick the starting ratio, which is the part people freeze on.

What you get back is usually a lower combined fee and the ability to see what you own without opening a nested holdings page.

So the verdict genuinely depends on the number in front of you. If the target date fund in your plan charges 0.10 per cent, the convenience is nearly free and assembling it yourself saves you almost nothing. If it charges 0.60 per cent, you are paying $56,000 over thirty years for an annual chore.

Two things to check on yours

The fee

It is on the fund's page in your plan portal, labelled expense ratio or net expense ratio. Some plans present it as a dollar cost per $1,000 invested instead, where 0.60 per cent shows up as $6.00 per $1,000.

Look also for whether the fund charges a fee on top of the fees of the funds inside it. Most reputable ones waive that layer, and the fund's own document will say so plainly.

To or through

A fund managed to the target date reaches its final mix in the year on the label and stops moving. A fund managed through the target date keeps shifting for a decade or two afterwards, which means it holds more stock in the target year than the first kind does.

Two funds with the same year on the front can therefore hold noticeably different things on the day you retire. The fund document states which design it uses, usually in the first paragraph.

Do not hold it next to other funds

The most common mistake I see with these is somebody holding a target date fund and then adding two or three other funds beside it in the same account, usually because a colleague mentioned one at lunch.

A target date fund is already a complete portfolio. Put 30 per cent of the account into a single sector fund alongside it and you have quietly overridden the glide path you chose, and the fund has no idea the other holdings exist, so it will never adjust for them.

Hold it on its own, or do not hold it. The half measure buys you the fee of the convenient option without the allocation it was designed to give you.

The year is the only dial

Since the label year is the sole input, it is also the only control you have. Choosing a fund with an earlier year gets you a more conservative mix sooner, and a later year keeps more stock for longer.

That is a real and legitimate use of the product rather than a trick, and it does not require you to know anything about the funds inside. What it does require is knowing what you would actually do if the balance fell by a third in a bad year, because that is the question the glide path is answering on your behalf.

Open your plan portal and write down two numbers off your fund's page: the expense ratio and the current stock percentage. If the fee starts with a zero point four or higher, look at what else the plan menu offers, because that gap compounds for every year you hold it.