Target-date funds are supposed to make investing easier and less risky. That’s why they have become enormously popular as a way to automatically make your investments more conservative as you grow older. 

So how have target-date funds performed in this tumultuous year for the stock market? They’ve done what they’re supposed to do, says fund ­expert Leo Acheson, CFA. That means they didn’t completely avoid the volatility, but they did help protect investors and smooth the ride. For instance, target-date funds designed for people who are retiring in 2020 dropped by an average of 17% during a 30-day “coronavirus sell-off period” ending March 20, compared with a 32% plunge for the S&P 500 Index of US stocks. However, the losses among various 2020 target-date funds ranged widely during that period—from 13% to 23%—reflecting big differences in how they invest their assets. Looking further out, target-date funds designed for investors retiring in 2035—who have more time to make up for setbacks—lost an average of 24%. 

Good news: Through June 26 this year, after stocks rebounded some, 2020 target-date funds were down an average of just 1.7% versus a drop of 7% for the S&P 500. The 2035 funds were down 5%, on average. 

Acheson says that this year’s chaos has highlighted the importance of knowing your target-date fund’s risk profile in order to avoid mistakes you might make in how you invest, as all target-date funds are not created equal. ­Potential mistakes include believing that your fund is less risky and less volatile than it actually is at any given point…assuming that it will offer adequate protection when nearing retirement…and failing to figure out what to do with money you have invested in the fund as you approach and enter retirement.

Acheson’s strategies for avoiding these mistakes…

Don’t Just Set It and Forget it 

Simplicity and one-stop shopping are central to the appeal of target-date funds. Typically, you invest in a single fund with a date closest to your retirement date, currently ranging in five-year intervals from 2005 to 2060. Then you let the fund managers worry about which investments to buy and how to rebalance the mix each year. The idea is that the fund will adjust the mix of stocks, bonds and other assets to make the fund more conservative as you approach and pass the retirement date.

But you still need to understand what you own and make some strategic decisions about your fund investments if you want to avoid costly mistakes…

Mistake: Thinking that all target-date funds are the same. Some of the fund providers take more aggressive ­approaches than others, meaning that different funds with the same target date offer very different levels of volatility. Typically, the higher the percentage of stocks, the greater the short-term volatility but also the higher the long-term returns. Among the various series of target-date funds from the leading providers, Fidelity Freedom and
T. Rowe Price Retirement take relatively aggressive approaches…American Funds Target Date Retirement Series, Blackrock LifePath Index, J.P. Morgan SmartRetirement and Vanguard Target Retirement take more moderate approaches…Charles Schwab Target Date, John Hancock Multi-Index Preservation and Wells Fargo Target Date are more conservative. What to do… 

Understand your fund’s risk ­level. Go to the fund family’s website or Morningstar.com, and examine portfolio allocations to stocks and bonds. Example: T. Rowe Price Retirement 2030 recently had 72% of its assets in stocks, 24% in bonds and the rest in cash. Its 10-year annualized performance of 9.4% ranks in the top 3% in its category. In contrast, Wells Fargo Target 2030 had just 62% in stocks and 35% in bonds. Its 10-year performance was just 6.7%, but the fund was also 30% less volatile than the T. Rowe Price fund over that period.

Select a target date that suits your risk tolerance, not just your expected retirement date. Choose a fund dated slightly earlier than your planned retirement for less volatility or a later one if you will be comfortable with the extra volatility. Example: If you are retiring in 10 years and have your investments in the T. Rowe Price Retirement 2030 fund, gradually switch to the 2025 fund if you are more risk-averse since it has a lower allocation to stocks (64% instead of 72%) and less volatility. 

Go to a different fund family if you feel your current one’s approach is too risky. Although your 401(k) plan typically offers target-date funds from just one provider, you can roll over some of the assets into a self-directed IRA, which gives you many more choices while maintaining your 401(k) for new contributions. Careful: Some fund ­providers may charge individual investors with IRAs an upfront load or high annual fees. If you want to keep your assets in your 401(k), ask your plan sponsor if you have an option to use a “self-directed brokerage account” or “brokerage window.” More than 40% of large employers now allow you to venture beyond the 401(k) plan’s core menu of investments and use target-date funds from other families.

Mistake: Glossing over the risks when you’re on the cusp of retirement. The average target-date fund holds 40% in stocks when it reaches its target date. Two of the largest target-date fund providers—Fidelity and T. Rowe Price—are more aggressive, holding about 50% in stocks. Reason: With increasing life expectancy, investors need to take risks now to generate the growth they’ll need in the next few decades to keep from running out of money. But steep portfolio losses near retirement could compromise your long-term ­financial plans, especially if you must soon start drawing on the assets, locking in your losses. In addition, some people find that they retire a few years earlier than planned because of ill health, layoffs or buyouts. What to do…

Sell some stock shares in the five years leading up to retirement to build up cash savings. This can be an effective way to reduce risk, especially if you don’t have savings outside of your 401(k). You need enough emergency cash that if your fund suffers big losses, you won’t have to tap the assets right away, allowing your portfolio time to recover. You also can raise cash by continuing to make contributions to your retirement plan but not investing the money.

Invest some or all of your retirement savings in the most conservative target-date fund your provider offers. This can lower your volatility significantly but still give you a chance for growth. Example: The Fidelity Flex Freedom Blend 2005 fund recently had 23% in stocks, 62% in bonds and 15% in cash. It has been 70% less volatile than the S&P 500, and during the coronavirus sell-off period, it lost just 10%. Through June 26, it was up three-quarters of a percent this year.

Mistake: Not determining how your fund fits into your plans once you have retired. Target-date funds continue on after they hit the target date. A few fund families such as BlackRock maintain a static portfolio allocation (40% stocks/60% bonds and cash) from that point on. But most providers continue to gradually lower the allocation to stocks and increase bond holdings each year. ­Examples: T. Rowe Price continues this process for 30 years after the target date is reached until its final allocation of 30% stocks/70% bonds and cash is reached. Fidelity continues for 20 years (final allocation: 20% stocks/80% bonds and cash). Vanguard, seven years (final allocation: 30% stocks/70% bonds and cash). The problem is that after you factor in income such as pensions and Social Security benefits, your need for additional income and the ability to draw down your portfolio may be more nuanced than what your target-date fund can provide. What to do…

Gradually liquidate enough of your target-date fund over several years to ensure that your short- and medium- term income needs are covered in retirement. To do that, you’ll need to put the money in relatively safe places including savings accounts, certificates of deposit (CDs) and/or bonds or bond funds. 

Another possibility: Many fund providers have rolled out “retirement ­income” funds such as Fidelity Freedom Income and Vanguard Target Retirement Income, which use a combination of mostly bonds and some dividend-­paying stocks to throw off steady ­income. Dividend-paying stock funds may look more attractive than bond funds now because yields are so low. 

Use what remains in your target-date fund as the long-term growth portion of your portfolio.