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The Short Answer

What Are Target-Date Funds?

Investors in target-date funds can set up a diversified portfolio and maintain a sensible asset allocation for decades without breaking a sweat.

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Editor's note: This article originally ran on Apr. 8, 2021. It’s since been updated to reflect new data.

There are so many options on a retirement savings plan menu, it's hard to know what to choose. But selecting good investments is only one part: Investors should also pay attention to overall portfolio diversification and not take on too much risk by being too heavily concentrated in any one area.

How the investments correlate with one another is another consideration. Modern portfolio theory says that investors can maximize their return potential and reduce the risk of losses by combining investments in asset classes that are not perfectly correlated with one another. A combination of investments like this is likely to do reasonably well in a variety of environments, because as one asset is falling, another is likely rising.

Once an optimal asset allocation is established, it's often advisable to rebalance back to the target allocations every so often, and to reduce exposure to risky assets like stocks and stock funds as retirement approaches. Whereas early on investors are focused on growing their wealth, as they approach retirement the focus shifts to preserving it.

These tasks are not impossible; certainly many investors manage their own portfolios and do it quite well. But there are a great many savers who would prefer to outsource the tasks of portfolio assembly, rebalancing, and gradually making their asset allocation more conservative. That's where target-date funds come in: They do all this for you.

What Is a Target-Date Fund?
A target-date fund is made up of other funds. The underlying funds offer diversified exposure to a mix of asset classes such as stocks (large caps as well as small/mid-caps), foreign stocks, bonds, foreign bonds, and maybe a small portion of cashlike securities. They are designed to be held throughout a person's lifetime, and the asset mix shifts dynamically, becoming less risky over a person's working career and into retirement. These funds achieve this by rebalancing portfolios over time to become less focused on growth (lowering their allocation to stocks) and more focused on preservation (raising their allocation to bonds) as the fund approaches and passes the target date. (The year in the fund's name corresponds approximately to the investor's retirement date.)

Target-date funds have become very popular: Investors had $1.6 trillion in target-date funds in early 2021. One reason is that the Department of Labor's Pension Protection Act of 2006 designated these funds as a Qualified Default Investment Alternative within 401(k) retirement plans, which are investment vehicles into which plan sponsors are allowed to place participants who do not make their own investment election. 

But their popularity also owes to their relative ease of ownership--they are truly hands-off investments that offer a diversified portfolio of building blocks with professionally managed allocations and automatic adjustments. 

What to Look For
Though you may be limited by your plan choices, there are many characteristics that Morningstar pays attention to when we evaluate target-date funds. Here are some things to look for.

Low fees
Unlike buying a luxury car, paying a high price for an investment doesn't guarantee you a better ride. It's important to pay attention to the overall cost of the target-date fund. Some providers layer on fees, and the resulting price tag represents not only the blended costs of the underlying funds, but also a layer of management fees that the advisor charges to implement the asset-allocation glide path. Look for low fees. (Note that the funds that are closer to their target retirement date will tend to be less expensive overall than later-dated options because their asset mix starts to tilt away from higher-priced equity fare and toward lower-priced fixed-income options.)

For instance, Silver-rated Vanguard Target Retirement 2020 through 2065 options range from 13 basis points (or 0.13% of assets) to 15 basis points. The portfolio is made up of low-cost index funds, and Vanguard does not charge a management fee to handle the dynamic asset allocation piece for investors. Also, target-date funds built around index funds tend to be cheaper than those built around actively managed funds. According to Morningstar's target-date landscape report, the average asset-weighted expense ratio for target-date funds was 0.52% at the end of 2020. 

Asset mix that suits risk tolerance
Some target-date funds invest more aggressively than others. Funds in the Gold-rated BlackRock LifePath Index series have an equity allocation exceeding 98% for investors targeting retirement around 2060, while Silver-rated series JPMorgan SmartRetirement has an equity stake of 85%--nearly 13 percentage points lower--for its similarly dated fund.

Investors can also drill down to the underlying exposure to foreign stocks (maybe your risk tolerance doesn't jibe with having a big stake in emerging markets, for instance) or fixed income (perhaps you would prefer to avoid high-yield bonds, as the Vanguard series does).

Check out the Portfolio tab on Morningstar.com's fund quote pages. There you will find statistics about the fund's portfolio. For instance, here is a quick peek at the asset allocation for Neutral-rated  MFS Lifetime 2035 A (LFEAX). You can see that stocks (both U.S. and non-U.S.) take up roughly 74% of the allocation from this big-picture view, and you can also drill down even further to see holdings by sector, country exposure, and market cap. (Click on the image below to see the Portfolio tab for this fund.)

A glide path that makes sense
The rate at which a target-date fund adjusts its allocations to stocks and fixed income over time is known as its glide path. Check to see how the fund invests over time and ramps down its equity exposure as retirement nears. Some invest more heavily in stocks throughout the life of the fund in the belief that a higher equity position--and the higher returns that typically come along with stocks--is necessary to ensure that investors don't outlive their savings.

Morningstar analysts can help you evaluate a fund's glide path and allocation. The Fund Analysis section contains a thorough evaluation of the fund's merits and drawbacks and our analysts’ overall rating. (The Fund Analysis section and Morningstar Analyst Rating are features of Premium Membership. You can sign up here for a 14-day free trial.)

The Fund Analysis is divided into six sections. Each analysis begins with a Summary, in which the analyst provides a summary of his or her overall opinion, which often discusses the most important or decisive factors leading to the fund’s overall rating. 
In the sections that follow, the analyst provides his or her evaluation of how well a fund scores in three fundamental areas (or Pillars): Process, People, and Parent. A fund’s overall rating is heavily influenced by the qualitative scores our analysts assign to these three pillars.

One-Size-Fits-Most
For many investors, target-date funds make a lot of sense, but they may not work for everyone. Outside of initially picking the fund, they don't offer investors control over their investment or allocation choices. Also, by choosing a target-date vehicle, investors are limited to a given fund family's funds; most target-date funds are use their own underlying funds to build portfolios. The drawback of that is that few fund companies offer best-of-breed funds across all asset classes.

In addition, they are intended to be used on their own. If satellite holdings are added--perhaps to add exposure to market sectors not represented in the target-date fund's portfolio--investors must take on part of the rebalancing task by recalculating the asset allocation of the entire retirement portfolio to make sure it's in line with targets. (Morningstar.com's Portfolio Instant X-Ray tool can help.)

Those caveats aside, target-date funds offer a great proposition for most retirement savers. They are no doubt the easiest path to setting up a diversified portfolio and maintaining a sensible asset allocation for decades.

Further Reading

Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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