Target Date Funds

If you are looking for a simple way to invest for retirement, you may have heard of target date funds. These are mutual funds that automatically adjust their asset allocation based on your expected retirement date. They are designed to provide you with a diversified portfolio of stocks, bonds, and cash that matches your risk tolerance and time horizon. But are they right for you? In this mini lesson I will explain what target date funds are, how they work, and some of their pros and cons.

 

What Are Target Date Funds?

Target date funds are a type of lifecycle fund that invests in a mix of assets that changes over time. The fund's name usually includes a year, such as 2050 or 2060, which indicates when the fund's investors plan to retire. The fund's asset allocation is based on a glide path, which is a predetermined schedule of how the fund shifts from more aggressive assets (such as stocks) to more conservative ones (such as bonds) as the target date approaches. A glide path is a formula that defines the asset allocation mix of a target date fund, based on the number of years to the target date. For example, a glide path may specify that a fund starts with 90% stocks and 10% bonds at 40 years to the target date, and gradually reduces the stock exposure to 30% and increases the bond exposure to 70% at the target date.

For example, a 2050 target date fund may start with 90% of its assets in stocks and 10% in bonds in 2022. By 2032, the fund may have 60% in stocks and 40% in bonds. By 2042, the fund may have 30% in stocks and 70% in bonds. And by 2050, the fund may have 10% in stocks and 90% in bonds. The idea is to capture growth potential when you are young and have a long time horizon, and to preserve capital and reduce volatility when you are older and have a shorter time horizon.

Target date funds are usually offered as an option in employer-sponsored retirement plans, such as 401(k)s or 403(b)s. They are also available as individual mutual funds that you can buy from brokers or fund companies. You can choose a target date fund that matches your expected retirement year, or you can pick one that is slightly earlier or later depending on your risk preference and personal circumstances.

 

What Are the Pros of Target Date Funds?

Target date funds have several advantages for investors who want a simple and convenient way to save for retirement. Some of the pros of target date funds are:

- Low minimum investments: You can start investing in target date funds with as little as $1,000 or even less, depending on the fund provider. This makes them accessible to investors who are just starting out and may not yet have enough money to build their own diversified portfolio.

- Professionally managed portfolios: Target date funds are managed by fund managers who have expertise in asset allocation, market analysis, and portfolio rebalancing. They take care of adjusting the fund's holdings according to the glide path and market conditions, so you don't have to worry about making investment decisions or monitoring your portfolio performance.

- Low maintenance for investors: Target date funds are designed to be a set-it-and-forget-it option for investors who don't have the time, interest, or knowledge to manage their own investments. You only need to choose one fund that matches your retirement goal and contribute regularly to it. You don't need to change funds or rebalance your portfolio as you get older.

 

What Are the Cons of Target Date Funds?

Target date funds also have some drawbacks that you should be aware of before investing in them. Some of the cons of target date funds are:

- One-size-fits-all approach: Target date funds assume that all investors with the same retirement year have the same risk tolerance and financial goals. However, this may not be true for everyone. For example, some investors may have other sources of income or savings that affect their risk appetite and asset allocation needs. Some investors may want to retire earlier or later than their target date. Some investors may have different preferences for active or passive management, growth or value investing, domestic or international exposure, etc.

- Higher expense ratios: Target date funds tend to charge higher fees than other types of mutual funds because they invest in multiple underlying funds that each have their own expenses. According to Morningstar, the average expense ratio for target date funds was 0.51% in 2021, compared to 0.39% for all mutual funds. Over time, these fees can eat into your returns and reduce your retirement savings.

- Lack of diversification: Target date funds typically invest in a limited number of asset classes, such as stocks, bonds, and cash. They may not include other types of investments that can enhance diversification and reduce risk, such as real estate, commodities, alternative assets, etc. They may also have biases towards certain sectors or regions that do not reflect the global market.

 

Conclusion

Target date funds can be a good option for investors who want a simple and easy way to invest for retirement. They offer low minimum investments, professionally managed portfolios, and low maintenance for investors. However, they also have some drawbacks, such as a one-size-fits-all approach, higher expense ratios, and a lack of diversification. Therefore, you should do your research and compare different target date funds before choosing one that suits your needs and goals. You should also review your fund periodically and make adjustments if necessary.