How do target funds work?

Retirement target funds are one of the most commonly used investment options in a 401(k). They are designed to follow a set glidepath that is generally 90% stocks and 10% bonds 20-25 years prior to the "target" date listed in the fund title (e.g. 2040). Once the fund reaches the "target" date, the allocation is typically around 50% stocks and 50% bonds. During that 20-25 year period prior to the "target" date, the fund gets slightly more conservative each year, following a "glidepath" along the way.

With that said, not all funds are created equal and not all funds follow the same glidepath! This video will outline things to look for in target funds, best practices with choosing the right target fund, and how to find your fund's glidepath.

Transcript:

On today's video, we're going to be talking about how target funds work. I'm Chris Kaminski, partner and co -founder here with Consilio Wealth, where we specialize in working with technology professionals, specifically at Amazon, Microsoft, Meta, and Google.

All right, how do target funds work? You will commonly see this as an option within your 401k. We always, always see people picking the date that they want to retire, say that's 2040 or 2030 or 2050 or whatever your date might be. But it's important to understand what that actually means and how these funds work.

Let's dive in.

Let's say that you pick the 2040 Target Fund. I want you to go and Google the ticker symbol to that fund. If you can't find the ticker symbol, because it's not on your statement or anywhere in your 401k profile, just plug the name in. If you're at Microsoft, it might say something like BTC Life Path. If you're at Google, it might say something like Vanguard Target Retirement Fund.

So just plug that name into Google and go to the Vanguard or respective site to learn about the holdings. All of these funds follow what's called a glide path. The glide path is the date at which you put in the fund, say 2040, that's the date at which the fund thinks that you will be retired. And on retirement, the fund is targeting a certain asset allocation or a certain stock to bond mix. Now here's the challenge. All of these funds are different. Vanguard has a different assumption of that. Fidelity is different. BlackRock's different. They're all different.

So it's important that you understand what the glide path is and if that's the right allocation for you. Oftentimes these funds will target something like a 50 -50 mix, 50% stocks, 50% bonds at that targeted date. Some of these funds will even continue to get more conservative into retirement. In fact, Vanguard funds get to only about 20 % holdings in stocks and 80 % in bonds. And that's about 10 years after your targeted date. Look this up, this is very important to understand how these funds work.

This is not a video about investment recommendations, but generally speaking, a 20% stock and 80% bond portfolio may or may not be the right fit for you as an investor. About 20 to 25 years before the targeted date is when the fund starts going down the glide path. What do I mean by that? Before that date, most of these funds are 90% stock, 10% bond. So if you pick a 2060 fund today, that's about 40 years in the future. I'm just ballparking here.

That fund is going to be a 90/10 portfolio, most likely, and it's going to hold that until about 25 years before 2060. Then it's going to start rolling down the hill. And every year, more specifically every five years too, it's going to move downward in risk. So it becomes an 80/20, it becomes a 70/30, 60/40, etc. The reason why this is important to understand is you might be picking a targeted date. Let's say you pick 2030. That fund could be 60% stocks and 40% bonds.

But let's say 2030 for you is not actually when you're going to retire. It's when you want to retire, when you want to hit financial independence, but maybe based on your financial plan, your plan is to not use any of your 401k funds in 2030. Maybe you're going to take those at say 73 or 68. Maybe you're planning on taking them many, many years down the road or into retirement. That allocation may not be appropriate given the time horizon of those funds.

So if you're picking a target fund because you like the simplicity of the allocation and just picking one thing, just make sure you understand what the allocation is and determine if it is appropriate for you.

Okay, one more thing to note. We commonly see people putting more than one target fund in their portfolio. I love that people are trying to diversify by buying more than one fund, but these are not generally designed to own more than one.

We'll see people buy the 2020 fund, the 2025, the 2030, the 2040, and they try to diversify in these five -year age bands. Again, if you looked this up, you would see what I mean. All of these funds own the same exact stuff, just in slightly different asset mixes. Again, it's all just triggering how much stock and how much bonds, or what percentage of stock and what percentage of bonds do these funds hold.

So generally speaking, you don't need to diversify across two funds. The only difference between those two are the stock and bond mix. Hope you thought this video was helpful. Thanks so much for tuning in.