Are Target-Date Funds a Good Investment?

The simplicity of these savings tools can be their greatest strength or their biggest drawback.

Kailey Fralick
Kailey Fralick
Feb 15, 2019 at 5:45PM
Investment Planning

If you find retirement planning daunting, a target-date fund purports to offer relief. They're designed to provide a "set it and forget it" investment solution for individuals with a long-term savings goal, like retirement. 

While target-date funds have certain benefits, their cookie-cutter approach also has its drawbacks. You may already have a target-date fund in your retirement account, as it's the default fund used by employers who auto-enroll their workers into workplace savings plans. But you can override your employer's deicison, and you should do some research before investing your precious retirement savings in target-date funds. Here's a look at the pros and cons of target-date funds and how to choose one that's right for you.

Tabletop calendar

Image source: Getty Images.

What are target-date funds?

Offered by retirement accounts providers and brokerages, target-date funds usually have names that include the targeted retirement year.

For example, if you plan to retire in 2030, you would choose a 2030 target-date fund within your 401(k) or IRA. Target-date funds are often mutual funds containing a variety of investment products, like stocks and bonds, to keep your money diversified. As you near the fund's target date, its asset allocation automatically shifts to align with your decreasing risk tolerance, so you don't have to worry about reallocating the funds yourself as you near the end of your career.

The benefits of target-date funds

Target-date funds are popular among hands-off investors for their simplicity. In theory, all you have to do is choose the right fund that corresponds to your planned retirement year and then sit back and wait.

The risk is selected for you by the pros: If the planned retirement date is a long way off, the fund will contain a larger percentage of higher-risk investments, like stocks. Then, as your retirement date gets closer, it will automatically adjust the asset allocation to account for your diminishing risk tolerance, moving more of your money into more stable investments that deliver income, like bonds. This way, you don't have to worry about losing a large chunk of your nest egg on the eve of your retirement if the stock market takes a dip.

The automated nature of these funds can also help to prevent emotional decision-making. Some investors may be tempted to buy or sell an asset impulsively based on recent performance if they're managing their own investments, which hurts the value of their savings over time. But with target-date funds, you don't have to worry about when to reallocate or what to invest in because these decisions are already made for you.

The drawbacks of target-date funds

The simplicity that makes target-date funds so appealing can also be their biggest drawback. The cookie-cutter approach cannot account for individual lifestyle changes or changing market conditions.

A target-date fund may seem like a good fit for you today, but it may not be in the future. For example, say you planned to retire in 2050, but then something happens and you end up retiring in 2040 instead. While the investments in your 2050 target-date fund may be well-suited to someone who is actually retiring in 2050, they may be too volatile for your new, diminished risk tolerance.

All target-date funds are different, even those with the same target year. The mix of investments and when your assets are reallocated varies from one to the next. This can not only impact the performance of the target-date fund, but also its cost.

Target-date funds can be composed of individual stocks and bonds, but they're most commonly mutual funds,  meaning they charge shareholders an expense ratio, or annual fee that's a percentage of your assets. Actively managed mutual funds -- those that are managed by a real person -- tend to have higher expense ratios than passively managed funds that track an index. If your target-date fund contains a number of expensive assets, the fees could eat into your profits and inhibit your portfolio's growth.

You can find out how much you're paying in fees by looking at the prospectus for your investments or by using FINRA's Fund Analyzer tool. Enter a fund's name and it will show you how the fund's fees will impact the value of your savings over time so you can estimate which target-date fund will provide the greatest return for the lowest cost.

The average target-date fund has an expense ratio of 0.66% per year, according to Morningstar. This means that for every $1,000 you have invested in the target-date fund, you will pay $6.60 per year. However, there are some target-date funds that only charge 0.12% or less per year. Look for one of these to keep your costs low.

How to choose a target-date fund

Target-date funds can be a smart addition to your investment portfolio, especially if you want a one-stop solution to retirement savings, but like any investment, it's important to do your research before handing over your hard-earned money. Look at the options for your planned retirement year and compare their investment allocations and costs.

Every target-date fund will have a unique mix of investments and a different glide path, or the rate at which the investments in the target-date fund shift from more aggressive to more conservative.

There are two main types of glide paths. A "to retirement" target-date fund is designed to reach its most conservative asset allocation on the target date. After that, its asset allocation will not change. A "through retirement" target-date fund will reach its most conservative asset allocation after your target date. This can make them a little riskier, but they may also continue to generate larger returns in retirement because of this.

Target-date funds are designed to be stand-alone investments, but if you want to invest in other things as well, it's important to be mindful of the asset allocation in your target-date fund. Calculate how much of your money in the target-date fund is in stocks, bonds, and other investments and decide if you're comfortable with this ratio. If you are, you may want to invest any additional savings similarly. But if you feel that your target-date fund is too conservative, for example, you may want to invest more in stocks in order to get to your preferred risk tolerance.

It's still a good idea to check in on your target-date fund periodically to see how it's performing and to ensure that you're still comfortable with the asset allocation. If for some reason you're not, you may want to consider switching to a different target-date fund or investing your money in other investment products instead. Remember, this is your retirement savings on the line, so it can't be taken lightly.

Check out the latest earnings call transcripts for companies we cover.