10 things to know about TDFs

Updated January 5, 2024 

TDFs, or target date funds, are growing in popularity. More and more investors are using TDFs for their retirement savings. 

The combined assets in mutual funds and collective investment trust funds are approaching $1.8 trillion, according to recent research. Additionally, the average 401(k) plan holds more than 22% of its assets in TDFs, which is a steady increase over the last decade.  

But how exactly do TDFs work? What are the different types? And what are the advantages and the risks? In this article, we’ll go over 10 things to know about TDFs. Financial advisers can use this as an education piece for clients and contacts when discussing TDFs as an investment option. 

1. TDFs are used for retirement savings. 

TDFs invest in a diversified mix of securities, which include bonds and stocks among other investments. Most commonly, TDFs are used for retirement savings. Investors select a target date fund based on the target date for their retirement.  

Investors with a 401(k) might already have a target date fund strategy in place that is managed with a retirement date in mind. They are widely available investment options and are often used as the default investment for 401(k) plans.  

Target date strategies are also held in 529 plans. In that case, the target date is usually the year the investor anticipates a child starting their secondary education.  

TDFs are built to invest across various asset classes and securities. Adjusting the mix of asset classes as the investor ages might help protect and grow their savings.  

The longer the investor has to invest, the more they can attempt to capture strong long-term growth potential. In other words, TDFs with target dates decades from now usually hold most of their assets in stocks.  

2. There are 3 different types of TDFs. 

All TDFs follow a glide path, which is the specific mix of assets that adjust throughout the life of the fund. However, different TDFs might use a variety of investment strategies. TDFs also come in different management styles, which must be considered.  

For instance, some TDFs are actively managed, some track benchmark indexes, and others use a hybrid of the two. These variations may impact the costs, allocations, and risks associated with the fund.  

Here is a look at the three different types of TDFs: 

• Active portfolio: Usually, active portfolio management teams select actively managed investments to outperform broad market indexes. 
• Passive portfolio: Passive portfolio management teams, on the other hand, select passively management investments more in line with an index, such as the Russell 2000 or S&P 500. 
• Hybrid: A hybrid portfolio management team uses a combination of the two previous options. This means the hybrid portfolio management team invests in actively managed investments when it makes sense. Otherwise, it uses passively managed investments in areas where the team believes active management fails to add significant value. 

3. The biggest advantage of TDFs: a diversified portfolio. 

TDFs offer numerous advantages. The biggest advantage is that TDFs can help you get invested in a diversified portfolio that is aligned with your investment horizon. This can help you manage key risks that you might face over your lifetime. These include longevity risk, market risk, inflation risk, and the risk of deflation.  

Let’s break down how TDFs manage these risks.  

Longevity risk   

Longevity risk is the risk that you may outlive your money. Investing for growth potential is one way to ensure your investments are, at minimum, keeping up with inflation. And ideally, they grow beyond that. Most TDFs maintain a healthy level of stocks up to the goal date and pass it. That essentially means that your money has the potential to continue growing. 

Market risk 

The market risk is the possibility that an investment could lose value due to changes in the wider market. An example came in late February 2020 when COVID-19 derailed the economy.   

It is impossible to completely remove market risk. However, TDFs help manage market risk by holding a wide range of investments. 

That type of diversification can help you through periods of market volatility. When one investment fails, other investments may succeed, even if they are by not falling as far. Again, diversification and asset allocation do not necessarily ensure a profit or guarantee against loss, but they usually help. 

Inflation/deflation risk 

Inflation risk is the possibility that increasing prices for goods and services will reduce your purchasing power. TDF allocations to stocks can help manage inflation risk.  

Historically, stocks have outpaced inflation over the long term. TDFs might also hold other investments that try to protect investors during inflation. These include real estate investments, Treasury Inflation-Protection Securities (TIPS), and commodities.  

TDF diversification strategies also protect against the opposite, which is deflation risk. This can be the risk that prices start to fall due to reduced consumer spending, slowing the economy.  

4. TDFs come with certain risks.  

One of the major risks of TDFs is that they may not change with the investor, their financial goals, and their financial needs. The reason is the predetermined shifting of the portfolio assets. An example is if an investor must retire significantly earlier than the target date.  

Another risk is there is no guarantee that the TDF’s earnings will keep up with inflation. Not only that, but there are no guarantees that the fund will generate certain gains or income at all. After all, TDF is an investment; it is not an annuity. Like any investment, TDFs are subject to underperformance and risk.  

Finally, TDFs can be costly. Technically, they are a fund of funds, or FoF. That is a fund that invests in other mutual funds or exchange-traded funds. This means having to pay the expense ratios of those underlying assets, in addition to the fees of the TDF.  

5. TDFs take the guesswork out of retirement saving.  

TDFs mix different types of bonds, stocks, and other investments into a single solution that helps prepare for retirement. TDF investments are riskier when investors are young, but gradually become more conservative as they get closer to retirement.  

Essentially, TDFs take the guesswork out of retirement saving. TDFs are managed by professionals and give a diversified mix of equities and fixed income that changes over the long term. Most workplace retirement plans use TDFs as their default investment.  

6. Investors can make money in TDFs. 

TDFs are structured to maximize returns by a specific date. The funds are typically designed to build gains in the early years of the investment by focusing on growth stocks that are riskier. Then, they aim to retain those gains by leaning toward more conservative, or safer, choices when approaching the target date.  

7. When investing in TDFs, choosing a target date is crucial.  

Anyone with a 401(k) plan may already be set up for a TDF, since most of those plans use TDFs as their default investment. Investors who don’t have a 401(k), however, may be in the market for a TDF and have some decisions to make.  

When investing in a TDF, investors will likely want to choose the fund with the name closest to their planned retirement date. Someone who is 30 years old and wants to retire at 65 may want to pick a TDF with a date close to 35 years in the future. If, on the other hand, an investor is 50 and wants to retire at 70, they will want to choose a fund with a date 20 years in the future. Investors should choose their target dates carefully.  

8. Consider the amount of risk your client can handle. 

First, compare funds with similar target dates. That will help you examine their investment strategies, which will help you select one that matches your client’s risk tolerance. Remember that circumstances may change along the way. Your client should monitor the fund’s performance regularly to make sure it meets their investment and retirement goals. 

9. The fund’s prospectus has information on target dates.   

To help you determine if the fund will take your client to or through retirement, read the fund’s prospectus. This will help clarify what the target date actually means. It will also help avoid being surprised by how the fund’s asset allocation changes in the long term.  

10. TDFs are a popular option for retirement, but is it the right move for your client? 

TDFs are growing in popularity as an investment for retirement savings. Whether it is the right move will depend on a number of factors. When deciding, weigh the advantages and the risks against your client’s financial situation and retirement goals.  

If TDFs are the right move, choose a target date carefully and consider your client’s risk tolerance. If done correctly, your client will have a dynamic way to save on the road to retirement.  

To find out more about TDFs, get in touch with one of the financial advisors that we highlight in our Awards & Recognition section. Here you will find the top-performing financial advisors across the USA.