Target date funds are a type of mutual fund designed to simplify retirement savings. Investing in a single target date fund is like buying into a fully diversified retirement portfolio that evolves with your needs as you age. The name is deliberate: Target date funds are designed to target your anticipated retirement date.
How Do Target Date Funds Work?
A target date fund is like owning an entire retirement portfolio in a single fund, which adjusts its holdings from higher-risk, higher-growth assets to safer, lower-risk assets as you grow older.
When you buy shares of a target date fund, fund managers invest your money in a broad portfolio of different index funds and mutual funds, rather than individual stocks or bonds. This makes target date funds a type of fund of funds.
Target date funds are typically named with the year you plan to retire or begin taking distributions. The further away you are from that date, the more the target date fund invests in equity mutual funds, which carry more risk but better growth prospects. Over time, the target date fund gradually adjusts its holdings to lower-risk bond funds to help preserve capital and generate income.
Consider a 25-year-old retirement investor—let’s call her Sasha—who has just entered the workforce. Sasha chooses a Target Date 2060 fund via her company’s 401(k) plan. Sasha buys a Target Date 2060 fund, which is presently invested in more stock funds than bond funds since Sasha has decades until retirement and can afford to take on more risk. While stocks might see near-term losses, a Target Date 2060 fund has lots of time to recover and grow substantially over the long term.
The Target Date 2060 fund managers will gradually adjust their asset allocation using a glide path. A glide path chart guides how the fund’s mix of assets will change from a higher-risk mix to a lower-risk mix as retirement nears. In Sasha’s case, this is a portfolio that’s 90% stocks in 2020 that glides to only 30% stocks in 2060.
The target date fund’s managers handle asset selection, buying, selling, and rebalancing according to the target retirement date of 2060. This lets Sasha focus less on retirement investing, periodically checking in on how her savings are coming.
Why Invest in Target Date Funds?
The advantage of target date funds is that they greatly simplify retirement investing. But there are some potential downsides you should be aware of.
Advantages of Target Date Funds
When you trust your retirement savings to a target date fund, you don’t have to spend time researching and managing different investments. Each target date fund contains a well-diversified mix of other mutual funds, so you shouldn’t need any other investments for retirement.
While target date funds aren’t precisely tailored to your individual preferences, you can select a fund that’s generally optimized for people who aim to retire around the same time as you—for many, if not most, people, and this could be all of the personalization they need. Target date funds are set-it-and-forget-it options for people who prefer hands-off retirement investing.
Drawbacks of Target Date Funds
Target date funds may charge management fees that are above average compared to other mutual funds. They are generally more expensive than index funds.
All mutual funds charge expense ratios—the fees that compensate the fund managers and pay other expenses. As funds of funds, each target date fund buys many other funds, meaning you are charged expense ratios for the target date fund and each of the funds it purchases.
High fees can eat into your returns. For instance, the Center for American Progress found that over a 40-year career, someone investing in low-cost mutual funds with expense ratios of 0.25% had about $100,000 more at retirement than someone investing in mutual funds with expense ratios of 1.30%. To make up the difference, the person investing in more expensive funds would have to delay retirement by at least four years.
You need to know the impact higher-cost target date funds costs can have on your retirement savings. Before you choose a target date fund, compare expense ratios and decide whether higher costs are worth the peace of mind.
In addition to potentially higher fees, target date funds don’t automatically adjust to changes in your life. If a significant life event impacts your finances or alters your retirement date, you may need to move your money to a fund with a new target date or change your asset mix to one that’s more aggressive to make up for the money you might withdraw early.
Finally, there’s no guarantee that the investment returns of the target date fund you choose will keep pace with inflation or generate the expected returns. As with any investment, past performance doesn’t guarantee future results.
How to Invest in Target Date Funds
There are three main places you can buy a target date fund:
- In your company-sponsored 401(k) plan.
- In an individual retirement account (IRA).
- Directly from a financial services firm like Vanguard, T. Rowe Price, or Fidelity.
You can buy a target date fund in a taxable online brokerage account, but you might not want to choose this route. Most target date funds are actively managed, to a degree, meaning their holdings change over time. This means you could face unintended tax consequences if you choose a taxable brokerage account rather than a tax-advantaged 401(k) or IRA.
How To Choose Target Date Funds
The fees, fund holdings, and past performance of similar target date funds can vary. Target date funds with the same end date might have drastically different asset allocations that could impact your long-term returns.
You’ll want to research your options before making your investment. Compare Morningstar ratings, which can help you evaluate the quality and performance of different mutual funds. Also, look at the initial investment requirement, past performance, and expense ratios.
If you’re investing via a company-sponsored plan, you might not have more than one choice for a target date fund. You should still compare the fees and performance of a single fund offering like this and decide whether it’s a good bet.
To better take advantage of dollar-cost averaging and compounding, consider setting up a recurring deposit to help keep your retirement savings on track.
Don’t Completely Set It And Forget It
While target date funds can be powerful tools to simplify retirement investing, you should still check in on your investment regularly. Keep comparing your fund to other funds in the same target year category. Don’t be shy about making changes if you’re not invested in a fund that offers the best rating balance, returns, risk, and fees.
Even if you’re investing through your 401(k), it’s still wise to check in now and again. While your investment options might be limited to a small offering of target date funds, make sure the one you’re in keeps up with average market returns. Otherwise, it might be time to switch your fund holdings to keep your retirement savings goals on track.