There are lots of investment options inside and out of retirement plans. Today, I want to help you get the most out of target-date and lifestyle funds.

There is a lot of confusion about how these funds work.

They have become the leading qualified default investment alternative (QDIA) in most retirement plans) 401(k), 403(b), etc.).

How do they work? What are the advantages and disadvantages? Are they as good as advertised? Aren't they expensive?

We'll answer these questions and help you figure out whether a target-date or lifestyle fund makes sense for you.

The basics of target-date funds

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They give employees the option of choosing one fund that diversifies their investments between stocks, bonds, and cash (the allocation) throughout a participant’s working life. The burden of selecting investment options goes from the participant to the professional fund managers.

The theory is that younger participants, having more years to retirement, can take higher risks, and have more of their portfolios in riskier assets (stocks) which provide the best opportunity of achieving higher expected returns. As participants move closer to retirement, the percentage of stocks, in theory, gets reduced and the percentage of bonds and cash increases (a more conservative approach). The timing and nature of these allocation changes are what's called the fund’s glide path. I'll talk more about that shortly.

Target-date funds have a date attached to their name. For example, it might say target-date 2040. The 2040 number is the chosen year of retirement for the participant. So, if a participant is currently age 43 and wants to retire at age 65, they would select this option. They are twenty-two years away from their age 65 retirement date.

QDIAs pre-target-date funds

Before these funds existed, the QDIA for participants was a money market fund or another cash account. The reason for this was to protect the employer and plan trustees (administrators). If a plan participant (employee) did not choose how to invest their money, a cash account was the default choice. As such, all money went into that account.

The problem with having money in a cash account is pretty apparent. Cash doesn't offer much of a return. If they pay one percent interest while inflation is two percent, the account has a negative real return (1% earnings minus 2% inflation = -1% real return).

Employees got wise to this and began putting pressure on employers and plan administrators to offer a better option. Target-date funds became that option.

Because the funds target an age-based portfolio with a pretty specific time frame, employers felt they were off the hook (mostly) for not offering a competitive QDIA. We can argue whether or not these are better options for building your portfolios another day. I'm merely providing a brief history of how and why these funds got to this point.

Related:

How to Invest Your 401(k) Money

The 4 Percent Rule – Is It Still Safe?

How to FIRE Up Your Retirement

Pros and cons of target date funds

The high number of investment options in many of today’s 401(k) plans can be overwhelming and lead to inertia from participants who feel overwhelmed and confused by all of the choices. Target date funds simplify the investment choices.

A recent study of over 15,000 401(k) plan participants’ investment returns over a ten-year period showed that participants invested in a professionally managed portfolio, like target-date funds, earned returns that were 1.9% higher than those who chose their investments. That’s a significant number.

Pros

Professionally managed – You don't have to choose the mix of stock and bonds in the portfolio. The fund manager does all of that for you. You select the target year, and they do the rest. That's the biggest reason these types of funds are so popular. Diversification – Even in low minimum investments, these funds offer broad diversification among the various asset classes. This kind of diversification is hard to implement with small initial investments. However, since close to 80% of these funds come from Fidelity, Vanguard, and T.Rowe Price, be sure you look at the underlying funds. They consist of proprietary funds run by their own company. Be sure you have real diversification in the underlying funds. Less hassle – Since the fund managers make the decisions on how to invest and when to change. You don't have to do anything. You continue your regular investments, and they take care of the rest.

Cons

One size fits all – Since the allocation decisions about risk are out of your hands, you may have more investment risk in your fund than you realize or want. People learned this the hard way during the last financial crisis. Take the time to understand the fund before making your choice. Higher fees – Many of the funds offered in 401(k) plans employ an active management philosophy. These funds have higher costs than index funds. High fees can dampen returns. If possible, choose low-cost funds made up of index funds. If there are no target-date funds with index options, pay close attention to the underlying fund expenses. Higher risk than anticipated – I alluded to this in the first point, and address it further below. How the manager reduces risk toward retirement is a critical component of the funds. Many owners of these funds thought they had much less investment risk than they did when the 2008 crisis hit. Know how they make changes and when

The Potential Pitfalls of Target Date Funds

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However, in 2008, some target dates funds dropped in value by as much as 40%. Many participants postponed their retirement because of those losses. If funds are designed to reduce risk as one approaches retirement, why did some funds lose so much value? USA News provides some answers – What’s Under the Hood of Your Target Date Fund?

The glide path

A target date fund’s glide path determines how and when allocation changes happen. If your fund is designed to help you get TO retirement, the managers should substantially reduce the amount invested in stocks as you near the desired retirement date.

A fund that’s designed to get you THROUGH retirement changes allocations based on a participant’s life expectancy. These funds will have a higher amount in stocks at retirement than the fund TO funds. Why? They assume you will hold the same fund throughout retirement, which could last up to thirty years with ever-lengthening life expectancies.

Participants planning on retiring within a few years of the 2008 market crash in funds with a fund TO glide path likely did much better than those whose allocations were designed to take them THROUGH retirement. Knowing which type of fund you own is critical to your ability to assess its risk.

The Costs

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Investment costs among target-date funds can vary significantly. Costs can have a significant impact on investment returns. In the PBS Frontline documentary, The Retirement Gamble, investment fees are cited as one of the primary robbers of return. Keeping investment costs low can significantly increase the odds of better investment returns. Determining a fund’s expenses isn’t always easy, but it is well worth the effort.

As we previously mentioned, index funds, if available, often have the lowest expenses of all mutual funds. Target-date funds are no exception. If index funds are part of the fund choices, you're almost always better of in these funds.

Four steps to choosing the right fun right

Decide what you want the fund to do for you –Do you want a fund that is at its most conservative allocation when you retire? Or a fund that will take you through retirement? Understand the funds’ glide path – Is it a fund to or fund through option? What are the target allocations? How are decisions about allocation made? Knowing the glide path and choosing according to your goals helps you make the right choice. Understand the risk – Think about how much loss you'd be able to take and still stay invested? How did the fund do in 2008? Would you have stayed invested? If not, perhaps you should look at a more conservative option. The key to successful investing is staying invested. Insist on lower fees – If possible, look for funds that invest in index funds. Target date funds using indexes offer some of the lowest costs. Rather than trying to beat market returns, index funds seek to achieve the market returns by replicating the securities in the index. Few funds ever beat their market benchmarks. Better to take what the market gives then pay high costs for funds which try to beat the market. They seldom do.

Lifestyle funds

Lifestyle funds are similar to target-date funds. They are meant to provide a means to accumulate money for a specific time. They are available in taxable accounts as well as retirement plans. With that said, it's important to understand there are significant differences in lifestyle and target-date funds.

Unlike target-date funds, most lifestyle funds don't have a glide path as you move toward your desired retirement date. Though they often have a target date to them, most lifestyle funds' allocation stays constant. You choose the fund based on your time horizon (when you plan to use the money) and risk tolerance.

If you risk tolerance says the best allocation (mix of stocks and bonds) is to have a 60% stock and 40% bond mix, that mix will stay constant throughout the life of the fund. In many ways, these funds are like traditional balanced funds.

Another name for lifestyle funds is LifeStrategy (Vanguard). Several fund companies call their offerings Lifecycle funds (Blackrock, John Hancock, TIAA).

Know what you're getting before investing in any of these funds.

Final thoughts

Though not a panacea, target-date and lifestyle funds offer a reasonable alternative to the often confusing world of too many investment choices.

Take the time to understand what you want from them. Find a fund that meets your needs. Keep costs low. Following the four steps outlined above can help you achieve better investment results and put you on a path to a more prosperous retirement.

I say this with one important caution. Don't look at these options as an easy way out of making smart investment decisions. Yes, they are convenient. Yes, they offer simplicity in your investments. And yes, some provide lower costs.

But like any investment you make, it's critical to understand what's under the hood (the funds), the glide path (how they change the allocation) and the costs (fund and management expenses). Too many people learned the lesson the hard way in the last financial crisis.

There are a couple of basic rules that hold true with any investment. The first is if you don't understand it, you should not invest in it. the second, if it sounds too good to be true, it probably is. Stay away.

Take the time to do your homework. If you do, you may find one of these investment styles to fit your needs.

Now it's your turn. Do you own target-date or lifestyle funds? Do you know the glide path? Have you checked the expenses? I'd love to hear your thoughts in the comments.