Target date funds: what they are, how they work
Target date funds are an increasingly popular way for Americans to invest for the future. In fact, more than $3 trillion was invested there at the end of 2021, according to Morningstar. And they’re especially popular in 401(k) plans, helping workers manage their retirement finances.
Here’s what a target date fund is, how it works, its pros and cons.
What is a target date fund?
A target date fund is a mutual fund (or exchange-traded fund) that gradually rebalances and reallocates assets as you get closer to retirement, typically shifting the majority of assets from riskier investments such as stocks to more conservative – or fixed income – investments such as bonds and cash. The fund is designed as a one-stop-shop investment with a diverse set of asset classes.
With a target date fund, investors choose the year they think they need to access the funds, say 2040, and then the fund management company manages everything from there.
How target date funds work
Building a well-diversified portfolio can be overwhelming for people who aren’t investment experts. Target date funds are popular because they simplify the process for participants, says Jean Young, senior research associate at Vanguard Investment Strategy Group.
Target date funds aim to alleviate the ongoing task of a successful investment strategy: rebalancing and optimizing asset allocations. Target date funds offer investors the ability to automatically allocate fund assets from day one. But these funds can also improve returns for investors. Some studies have shown that up to 90% of an investor’s return depends on how money is allocated among different asset classes, from equities such as domestic and global equities to fixed income investments such as bonds and cash.
Target date funds, often a type of mutual fund, are a “set it and forget it” investment option. Once participants set their contribution from their paycheck and select the funds, the fund’s asset mix automatically adjusts, slowly becoming more conservative as participants age and approach retirement .
Consider, for example, a 2060 target date fund, which is aimed at investors who plan to retire by 2060. At the start of the fund timeline, assets are biased toward higher risk, higher return assets. high such as stocks. As the fund approaches its target year, risk is reduced through a more conservative portfolio of fixed income investments.
This change from aggressive to conservative does not happen overnight. Instead, a target date fund operates on a glide path. Think of an aircraft descending on final approach to land. The sliding trajectory of a target date fund uses a similar logic – facilitating the investor to a safe financial destination in retirement.
“That’s why target date funds are growing at Vanguard and all major providers,” Young says. “It’s just easier for people.”
At the end of 2020, 62% of all participants in the Vanguard plan were solely invested in an automatic investment program, up from 7% at the end of 2004. More than half of participants (54%) were solely invested in a single target date program. funds, according to Vanguard’s “How America Saves 2021” report.
Advantages of target date funds
The growing popularity of term funds is due to the significant advantages they offer to investors.
You can put your investing activities on autopilot
A target date fund eliminates the need to constantly monitor and adjust your portfolio and reduces the stress associated with financial planning as you approach retirement. The fund has a defined trajectory when allocating assets in the portfolio. As you approach your target date, the fund will gradually make your portfolio more conservative, helping you ensure your money is there when you need it.
You can make adjustments if needed
If your time horizon changes, you can switch to a more applicable fund. If you determine that you are going to work for another five years, you can transfer your money to the target date fund in 2065 or even later, if necessary.
Lower fund fees
As target date funds became more popular and had to compete with cheaper funds, their fees fell significantly. Their asset-weighted average expense ratio was 0.34% at the end of 2021, according to Morningstar. This means that an investor would pay $34 per year for every $10,000 invested. That’s down from 0.66% in 2017, or $66 per year.
So when it comes to expenses, target date funds compare well to the average mutual fund, although the average expense ratio is still higher than the average ETF.
Disadvantages of target date funds
Of course, target date funds have some disadvantages compared to other funds.
Fund expenses can add up
Saving for retirement requires spending money. Target date funds all have expense ratios, and it’s important to compare them before choosing one for your money. You may notice that some target date funds have higher fees than the index funds they contain. Keep these expenses as low as possible to maximize your potential earnings.
Although fees have gone down, you may be able to find cheaper funds and manage the portfolio yourself.
No winnings are guaranteed
Target maturity funds are investments, and all investments have the potential to lose value. It’s a simple reality of saving for retirement: you have to accept a certain degree of risk when investing for retirement.
Funds can get too conservative too quickly
As you approach your target date, target date funds move more of your money from stocks to bonds. However, this approach reduces your overall potential return, creating a drag on performance in exchange for relative safety. If the fund transfers too much money to bonds too quickly, it could seriously affect your potential retirement income. And since many seniors live more than two decades after retirement, retirees may need the additional growth provided by equities.
One solution: buy a target date fund five or ten years after the date you actually want to retire. This newer fund will have a higher equity allocation, potentially giving you more growth.
Are target date funds a good investment?
Target date funds help people wade through the investing waters, says Jennifer Shulman, owner of Simply Balanced Solutions LLC, a Florida-based professional daily fund management firm.
But she points out that they don’t solve all problems for everyone all the time. In the long run, people will want to see a certified financial planner for advice on good portfolio composition and knowledge about the limits of passive investing through target date funds, she says.
While a target date fund can be a simple way to allocate your money to investments that match your age and retirement needs, not all target date funds are created equal. For example, a 2060 fund from one provider may be more aggressive with more equity money than another 2060 fund from a different provider. To determine if the target date fund is a good investment for your needs, read the fund’s prospectus and review the current portfolio allocation and fee structure.
Keep in mind that the target date represents the start of another chapter in your life. The fund prepares you for retirement, but you’ll also need a plan to grow your money after you leave the workforce. Once the fund reaches its target date, it transitions to a retirement fund. At this point, consider keeping some of the money in the fund while allocating some of the money to other investments to earn regular income from your savings.
As part of this transition from work to retirement, it may be worth meeting with a financial advisor. A good advisor can help you make the right choices for your situation, by putting in place a financial plan that takes into account your entire financial plan, including Social Security. (Here’s how to find a financial advisor who will work in your best interest.)
“In the accumulation phase, the target date fund does a pretty decent job when the only thing we know about you is the year you might retire,” Young says. “At the end of the day, we should all have a personalized solution that takes into account not only what you have in your current plan with your current employer, but also all of your assets.”
At the end of the line
Target date funds offer a good, but not perfect, solution for investors who don’t want to manage their retirement portfolio themselves. Despite their drawbacks, many investors will find them a valuable addition to their portfolio, and they are becoming cheaper, meaning investors can enjoy their benefits for only a relatively small premium compared to traditional funds.
Note: Adrian Garcia contributed to a previous version of this article.