What Happens to Your Target-Date Fund When You Retire?

Note: This article is part of Morningstar’s January 2014 401(k) Week special report. An earlier version of this article appeared July 10, 2012.

Question: If I put money in a target-date fund, what happens once its target year passes? Do I get my money back? Does the fund's allocation mix stay the same, or does it continue to change?

Answer: Target-date funds--prepackaged portfolios of stocks, bonds, and other asset types that automatically ratchet down risk exposure as a given year approaches--have become an increasingly popular investment vehicle, especially in 401(k) plans, some of which now automatically enroll employees in the funds. At the end of 2012, 41% of 401(k) participants owned target-date funds, with the funds accounting for 15% of all 401(k) assets, according to the Investment Company Institute. Total assets in target-date funds reached $623 billion at the end of last year, up from $484 billion the year before, according to Morningstar data.

The idea of a target-date fund is simple: You pick the fund with the date that most closely matches the year you expect to retire. The funds are designed to adjust their asset allocations over time, with their percentages of stocks decreasing and the allocation to bonds and other asset classes increasing as the target date approaches. The rate at which allocation adjustments occur is referred to as the target-date fund series' "glide path."

Although target-date funds are simple to use, many investors are still confused about what to expect when the fund reaches its target date. Some mistakenly believe that investing in one of these vehicles guarantees them the income they'll need in retirement.

'To' vs. 'Through'
Even investors who are clear on what target-date funds can and cannot do might be fuzzy on the logistics of how these funds work. To answer your first question, different target-date series take different tacks when funds reach their target dates. Some fund companies convert the assets to a retirement-income fund at the target year, while others do so years after the target date is reached. Still others maintain the assets in the original fund and keep the same name, even if the target date has passed. For example, Vanguard Target Retirement 2010 is still alive and well, even though it hit its target date four years ago.

As for what happens to the investment mix when the fund's target date is reached, there are two basic approaches, referred to as "to" or "through" glide paths. A "to" glide path means that the fund manager stops adjusting the fund's allocation at that point, while a "through" glide path means that the manager continues to adjust it beyond that date.

As discussed in a 2012 research paper by Morningstar fund analysts Josh Charlson and Laura Lutton, one of the key differences between target-date fund series with "to" glide paths and those with "through" glide paths is that, even though both start out with similar allocations to equities, the average "to" path decreases this allocation more rapidly than the average "through" path. (See the chart below.) In fact, the average "to" path hits the target retirement year with a 31% allocation to equities compared with 49% for the average "through" path. The average "through" path then continues lowering its equity exposure for the next 20-30 years before landing at a final allocation of 28%.

This difference in equity allocation suggests that "through" glide paths are typically designed to provide greater protection against longevity risk given that equities tend to outperform other asset classes during long periods of time, whereas "to" glide paths are more oriented toward reducing the risk of exposure to a sharp downturn in stocks when the investor is close to retirement.

Out of 46 target-date fund series glide paths examined in the study, 28 were "through" while 18 were "to," an increase from the previous year's study, when 22 out of 41 glide paths were "through" while 19 were "to." Incidentally, target-date series that convert assets to retirement-income funds are found among both those with "to" and "through" glide paths. (For some of the pitfalls of relying on target-date funds for retirement income, read this article by Christine Benz, Morningstar's director of personal finance.)

Many Other Factors to Consider
Morningstar's fund researchers caution that the "through" and "to" designations are only one piece of the story when comparing target-date funds, and that there is a broad range of allocations within both types of glide paths. For example, American Century offers a "to" target-date fund series glide path with a final equity allocation of 46%, closer in that regard to the average "through" series percentage at the time of retirement (49%) than to the average "to" series figure (31%). So bear in mind that just because a target-date fund series keeps its allocation static after retirement doesn't mean its allocation is right for you. Other important considerations include the quality of the fund's underlying portfolio of investments, fund management, and cost.

Glide Paths and Retirement Plans
One group that needs to pay particular attention to the "to" versus "through" distinction is retirement plan sponsors, who have to think about how their employees are likely to use the target-date funds they offer. "Through" glide paths tend to be more ideal for retirees who are expected to stick with a target fund into retirement or who might continue working beyond the retirement age, while "to" glide paths are better-suited for those who are expected to withdraw assets at retirement and put them somewhere else, such as into an immediate annuity.

For participants whose investing profile doesn't match up with the contours of their employer's plan, improvising might be in order. They could simply choose an available target-date fund with a more aggressive or more conservative allocation, for example. Another idea is to supplement the target-date fund using other investments. For example, a participant who is concerned that a target-date fund's "to" glide path is too conservative and might not produce a large enough nest egg may want to add equity holdings to his or her retirement portfolio. Likewise a participant offered a target-date fund with a "through" glide path that keeps equity exposure uncomfortably high into retirement might seek to lower his or her risk profile by adding investments in other asset classes. (Of course, allocation issues might be present regardless of whether a "to" or "through" glide path is used, and these approaches work in those cases, as well.) Morningstar director of active funds research Michael Herbst has written about the need for investors to consider complementary holdings, in addition to target-date funds, to achieve specific goals.

Target-date funds make for an easy and convenient way to hold a diversified retirement portfolio, but don't let their ease of use fool you. Any target-date fund investor would be well-served to find out what's in the fund's portfolio, what its glide path is, and whether that glide path levels off at retirement or keeps on moving. Some of this information might be contained in the benefits materials your employer provides, and if it's not, ask where you can find it. One excellent resource is Morningstar's Target-Date Fund Series Reports, found  here.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.