Target-date funds (TDFs) have grown in popularity over the last decade, especially among those who lack confidence in their ability to allocate their assets properly. In theory, all you have to do is pick the right TDF, contribute money regularly, and then enjoy the results in retirement. But despite their growing use, there's a lot about TDFs that people still don't understand.
When asked how a TDF provides income in retirement, 64% of those surveyed by financial services organization TIAA said that it provides a guaranteed monthly check. It can, but many of them don't. To make things more confusing, some provide monthly payments, but they're not guaranteed. Here's a look at how it all works.
How does a target-date fund work?
A TDF is a type of mutual fund (a collection of investments) designed to help you instantly diversify your portfolio to reduce your risk of loss. But TDFs differ from regular mutual funds in how the assets included in the fund change over time. A regular mutual fund will experience some turnover, but its portfolio will remain similar over the years, whereas TDFs are specifically designed to become more conservative over time to suit a person planning to retire in a given year.
TDFs often have years in their names, and you choose one that corresponds to when you plan to retire. For example, if you plan to retire in 2050, you would look for a TDF with a 2050 target date. When that date is far off, the investments in the fund will be more stock-heavy to help you earn larger returns. And as that date gets closer, the investments become more conservative as your risk tolerance decreases. The idea is to provide a relatively hands-off retirement savings vehicle for those who lack the knowledge or the interest to manage their investments themselves.
Your TDF may include a number of different assets, like stocks and bonds. Typically, when you need to draw upon your savings, you sell the assets you've accumulated and your earnings and your initial investment come back to you as cash. In that sense, most TDFs are just like most mutual funds.
But some TDFs include annuities, and in that case, they would provide a guaranteed source of income in retirement. An annuity is a contract you make with an insurance company where you agree to pay in a certain amount over a certain period of time, and in return, it promises to provide you with guaranteed payments beginning either right away or at some point in the future for a certain number of years or for the rest of your life.
If your TDF doesn't include an annuity, it doesn't provide a guaranteed source of income, but it can still be a valuable addition to your retirement savings plan.
What about target-date funds that offer monthly payments?
TDFs with annuities will provide a guaranteed monthly check, but don't assume that every TDF that offers a monthly check includes an annuity. Vanguard, for example, has TDFs that include a systematic withdrawal plan. This is similar to an annuity in that it will provide you a monthly check, but the goal is only to "provide some reasonable level of income over time." Not for your entire life. With a systematic withdrawal plan, you will gradually draw down the money you've invested in the TDF, but once it's gone, that's it. The checks stop.
If you're not sure whether your TDF includes an annuity or uses some type of systematic withdrawal plan, read through the fund's prospectus or contact your retirement plan administrator to ask. It's important to understand this before you begin relying upon these savings in retirement. If you thought that your TDF would provide guaranteed income and you find out it doesn't, you might have to increase the amount that you save each month in order to have enough for the retirement you envisioned.
Those just exploring their options should look for a TDF with an annuity if guaranteed income is high on their priority list. Another option is just to invest in an annuity itself. But be careful with these, too. Annuities will offer you a guaranteed monthly check, but they often have complex structures that many find difficult to understand, and they can be costly. Plus, there's always the risk of losing money if you don't live long enough to recoup the principal you invested in the annuity.
As TDFs become more widely available, it becomes increasingly important to understand how they work. If you're considering adding one to your retirement plan, make sure you understand what you're investing in; whether yours will provide you with monthly checks; and if so, whether they will last for your entire life. That way, you won't have any surprises when you begin to draw upon that money in retirement.