Retirement planning: How to make the most of Target Date Funds

When it comes to investing their money for retirement, many people feel uncomfortable making every single investment decision, especially over a long period of time. They want a point-and-shoot, “do-it-for-me” option.

One result of this desire are Target Date Funds (TDF), which invest your money in a broad spectrum of investments and are adjusted over time to become more conservative as you approach your “target” retirement age. This gradual adjustment is aimed at reducing big fluctuations in value. People who work in finance call this “reducing volatility,” “taking a more defensive stance,” or “selling equities and adding more fixed income.”

TDFs, which are prevalent in workplace retirement plans, usually include a number in the plan’s name, such as 2040 or 2060, so that someone interested in using them can select the year that is closest to when they think they might retire.

A 55-year-old person looking to retire at age 65 might then select a 2025 fund, because that’s about 10 years from now. Easy enough, right?

But how well do you know what really happens to your money after it gets into that TDF? A major factor in how effectively your money is being invested depends on who is doing that behind-the-scenes work to shed some investments and add others.

The first thing you should know is that they don’t do this for free.

TDFs are made up of many different investments, typically, but not necessarily all, mutual funds. This is why they’re often called “funds of funds,” meaning that someone decides to buy or sell different funds in order to build that diverse portfolio for you. You’ve probably heard of Large Cap Funds and Small Cap Funds, and U.S. Funds and Foreign Funds, and Stock Funds and Bond Funds. TDFs simply invest a little in each, as well as some others, and then monitor your investments over time.

You should also understand the difference between “open” and “closed” TDFs. These are terms that describe what investments the person managing the process might use. It helps to think of this process a little like building a sports team. If you were building your own team, would you simply take over a team that someone else had built, or would you want to pick players from several different teams, as in fantasy sports leagues?

If you think picking the players you want, regardless of which team they play for, sounds better, then you’re probably more interested in what are called open TDFs, in which the fund manager can consider all available funds, often even looking beyond just mutual funds to other types of investments.

Closed TDFs, on the other hand, mean that the person making the decisions can only pick from one lineup of funds. This means that they cannot pick the best fund, only the funds that their employer offers. Add to this the fact that there is not likely to be any price difference between the two options, and you’re likely to find most people interested in open TDFs.

To sweeten the deal even more in favor of open vs. closed, you should know that many open TDFs can use all sorts of cost-saving investments such as Exchange Traded Funds, which are similar to Index Funds but often cost less.

Knowing all this, it might surprise you to know that the overwhelming majority of TDFs are closed.

If you’re looking for a reason why, you might not have to look any further than your retirement plan provider. Many retirement plan providers – the companies that provide support for your plan such as maintaining legal documents and creating your statements and the website – also offer TDFs. In order to sell more of these and make more profit, they might offer to reduce other charges, such as their fee to administer your plan. Or they might simply put them in the plan hoping that your employer doesn’t ask about potentially less expensive or better-performing alternatives.

This doesn’t mean that mutual funds or closed TDFs are bad, or that other ways of investing produce better results. It really just has to do with whether or not you want the professional managing your money to be limited in their options, or to have access to the ones that will best serve your interests.

Open and closed TDFs may be unfamiliar terms to you because mostly the debate has, to a great extent, been managed by the three main firms that hold the majority of the $800 billion that’s been invested in such funds. They’ve been creating massive marketing campaigns promoting the value of their TDFs – and thereby somewhat controlling the debate – for many years. All three of them are closed funds.

Here’s what to do with this information if you have TDFs in your workplace retirement plan:

• Look up the TDF on the Internet and find out who manages the money. If it’s the same company that offers your retirement plan, ask your employer if there are alternatives. The provider might threaten to increase costs somewhere else, but a good professional plan advisor or someone knowledgeable at your company can likely press them into it.
• Look up the investments that are being used. If you see that all of the investments begin with the same name, inquire about more open alternatives that aren’t as constrained.
• You might even find a “custom model manager,” who builds custom TDFs exclusively for your plan, often using a mix of the investments from your plan so you can more easily see what they’re doing. These custom managers are sometimes less expensive as well, because they can use less expensive investments to meet your objectives. Some plan providers offer this service. Many allow your plan to add a professional manager chosen by your plan.

It pays to get informed about your TDFs to make sure your money works as hard as you do.

Learn more about Jonathan on NerdWallet’s Ask an Advisor.