As you invest for retirement, you have several different options. One option you should consider is a target-date fund. These products are mutual fund or exchange-traded funds that are structured to optimize asset growth along a pre-established timeline. When you invest in a target-date fund, you choose the date you plan to retire and the asset allocation automatically changes over time to become more conservative as you get closer to that target.
In general, these are very long-term investments, with some having a time horizon of up to 50 years. The predetermined time horizon is used to calculate the appropriate amount of risk to promote growth and then slowly transition toward maintenance. Usually, the allocation is adjusted annually.
Key Points to Understand about Target-Date Funds
Once they are established, target-date funds may invest in very speculative assets that are high-performing in nature. Often, these funds invest in domestic and global equities that have significant growth potential, but are higher risk when established. Over time, the fund will begin investing in lower-risk vehicles, such as fixed-income assets, including both bonds and cash equivalents.
Before you invest in a target-date fund, be sure to check out the allocation glide path, which will show the intended shift of assets over the entire investment time horizon of the fund. The most conservative allocation will be achieved right at the specified target date and remain that way to protect your wealth once you are retired.
Not all target-date funds operate the same way once the target date is reached. Some funds will operate as “to funds,” which means they will cease any modifications to the asset allocation at the target date. In this case, you’ll need to become more active in managing your assets and ensuring the allocation is appropriate for you.
In contrast, “through funds” will continue to manage your investments even beyond the target date. At this point, the allocation generally moves even more toward low-risk, fixed income investments. You should know how your specific fund operates so you can plan what to do once you have retired. Even if you invest in a through fund, you may find that a different allocation would serve you better.
Why You Might Consider a Target-Date Fund
Target-date funds have some clear advantages. They are popular 401(k) investments because they allow people to avoid having to choose several different investment options at once. Choosing a number of different investments that work together to get you to your goals can be difficult and stressful—it requires a lot of research and time. A target-date fund takes almost all the work out of it. Instead, you can choose a single fund that is then managed with your particular goals and time horizon in mind.
They also prevent you from being your own worst enemy. Inexperienced investors who manage their own portfolios are sometimes easily spooked—they react too quickly to every little downturn. If you invest in a target-date fund, there are no guarantees, of course, but at least you won’t be tempted to pull your money prematurely.
The other benefit of target-date funds is there are funds targeted for any year you might retire. You can invest in a target-date fund whether you’re 25 and have 40 years until you retire, or you’re nearing 60 with just a few years left in the workforce. All of the questions about appropriate asset allocation are removed from the equation.
A few financial professionals argue that a target-date fund is the only investment you need in a retirement plan. After all, adding additional investments could end up skewing your overall portfolio allocation in a way that you do not intend. These funds are already designed to have appropriate asset allocation.
The upshot is that target-date funds can work well for people who want a completely hands-off approach to investing for retirement. You won’t need to think about your asset allocation each year and make adjustments since all this legwork is done for you.
Issues You Need to Consider Before Investing in Target-Date Funds
At the same time, some issues can arise with target-date funds, and you need to consider them before investing. The main issue is that these funds are on autopilot and you may find that the portfolio shifts do not suit your own changing goals down the road. For example, what if you end up needing to retire much earlier than you expected, or you decide to keep working longer?
Similarly, another potential downside is that by nature, these funds are “one size fits all.” They operate on the assumption that your retirement year is the only consideration in an investment strategy—which is an oversimplification that may not work for many people.
Another point to consider is that target-date funds do not guarantee any sort of return and it is possible that they may not even keep up with inflation. These funds are not an annuity, so there are no guarantees involved. (Of course, this is true of all investments.)
In addition, target-date funds tend to be more expensive, since they are a fund of funds. You will need to pay the expense ratios of the underlying assets and the fees of the target-date fund. However, more funds have become available that do not charge any fees, and overall, the charges associated with them have been decreasing, so this may not be a problem.
At any rate, you should definitely ask about fees when you’re considering different target-date funds. Make sure you are not losing most of your return on fees. In addition, pay close attention to the investment philosophy of the fund. There may be multiple funds with the same target date, but this doesn’t mean they all have the same allocation strategy. Some will be more aggressive than others, and this can affect both risk and returns, as well as associated fees.