A target date fund is a mutual fund that balances investments across multiple asset classes over time. Target date funds invest more in stocks and other higher-volatility assets when they're far away from the target date, and rebalance toward bonds and other lower-volatility assets as they approach the target date.
Who should use a target date fund?
Target date funds are typically used as a simple way to invest for retirement. When it comes to planning for retirement, target date funds are a set-it-and-forget-it approach. Pick your expected retirement date and put all your retirement savings in that fund. Easy peasy.
Target date funds can also be used for other long-term investment goals like saving for a child's college tuition.
Many workplace 401(k) retirement plans offer target date funds for their employees. In recent years, many investors have been opting to use target date funds in their IRAs as well.
If learning about asset allocation and rebalancing your portfolio over time isn't of interest to you or it's over your head, a target date fund may be the best option for you to ensure appropriate investments in your retirement accounts.
But you will pay a fee for that convenience. Target date funds charge an expense ratio that can climb up to around 1%. That said, some target date funds that rely entirely on low-cost index exchange-traded funds (ETFs) charge relatively low fees, some below 0.1%.
Check the fees of any funds available in your 401(k) plan or IRA to make sure you're not overpaying for the convenience. If there are low-cost index funds available in your retirement plan, but the target date funds are expensive, you might consider taking a few hours to read about asset allocation and develop your own plan.
A look inside a target date fund
A simple example of a target date fund is the Fidelity Freedom Index funds. These target date funds provide an asset allocation across domestic equities, international equities, bonds, and cash equivalents.
For the early years of each fund, Fidelity allocates 54% of the portfolio to a domestic equity index fund. Another 36% goes to an international equity index fund. That makes the total stock allocation 90%. Seven percent of the fund's assets goes to investment-grade bonds through another index fund, and it invests the last 3% in a long-term Treasury bond index fund.
About 20 years out from the target date, the fund manager will start shifting more investments into the investment-grade bonds and out of the equity funds. About 15 years out, they'll put a small amount of the portfolio, about 3%, in an inflation-protected bond index fund while continuing to shift assets from equities to bonds and T-bills. At 10 years out, the manager starts adding a small amount of short-term Treasury bond and money market index funds into the mix. By the time the fund reaches the target date, the asset allocation is split nearly 50/50 between equities and bonds.
As the fund moves past the target date, the fund manager continues to shift assets into lower-volatility asset classes, ultimately landing with 25% invested in equities, 55% invested in various types of bonds, and 20% in short-term bonds and money market funds.
Since the Fidelity Freedom Index funds use a limited number of low-cost index funds, the expense ratio is relatively low at just 0.12% per year. Fidelity also offers target date funds that use traditional mutual funds and allocates investments across growth stocks, value stocks, and all sorts of fund options. It charges 0.68% for this more complex option, but the returns are comparable to the index fund option.
Pros and cons of target date funds
There are a couple big benefits to owning target date funds:
- It's a very simple investment choice. Most 401(k) plans only offer one target date fund (with multiple options for the exact target date). So, if you're going to use target date funds, the choice is straightforward. You don't need anything else in your retirement portfolio.
- Automatic asset allocation adjustments. You don't need to manually rebalance your portfolio on a regular interval or adjust your asset allocation as you get older.
But there are drawbacks as well:
- It's a one-size-fits-all approach. Target date funds use the same asset allocation for everyone, regardless of their risk tolerance or actual goals. If you hope to retire early, for example, you'll likely need to invest more in stocks for longer than most target date funds suggest.
- The fees can be very high. Expense ratios for target date funds can approach 1%. While that might not sound like a lot, a 1% fee compounds into a lot of lost investment returns over the course of a career.
- No control over your investments. You don't get to choose which funds a target date fund invests in. That lack of control can be freeing for some, but frustrating for others.
Target date funds versus index funds and other mutual funds
Target date funds shouldn't be confused with index funds. Exacerbating the problem are a group of target date funds called "target date index funds."
A target date fund is typically a fund of funds. That is, it pools money from investors, and it puts that money in various mutual funds to obtain an appropriate asset allocation. A target date index fund exclusively uses index funds instead of mutual funds focused on a certain investing strategy like growth stocks or value stocks. This can result in lower expense ratios while providing similar returns as target date funds using strategic mutual funds.
An index fund, on the other hand, pools investors' money, and then invests in individual securities to track the returns of a certain index. So, if the fund tracks the S&P 500 index, the fund manager will invest in all 500 (or so) stocks that are part of the S&P 500. The weight of each stock in the portfolio is based on its relative market capitalization.
Index funds are considered passive investments because the manager only updates the holdings when the benchmark changes, as the goal is to track the returns of that index as closely as possible. Actively managed mutual funds, on the other hand, will update their holdings in hopes of outperforming the benchmark index. That often results in more trading fees and taxes as well as higher management fees.
A target date fund has a different goal entirely. It's designed to de-risk the investment portfolio over time by adjusting asset allocation. So, when you're further away from the target date, you'll experience better returns but greater volatility. When you get closer to the target date, however, there's less risk of the portfolio experiencing a massive decline in value, at the cost of lower expected returns.
Understanding your investment options, the pros and cons of target date funds, and how they work can help you maximize your retirement savings.