While browsing your employer’s 401(k) options or searching for a fund to open in a brokerage account, you may have come across target date funds. Some people love these so-called “set it and forget it” funds, while others dislike them for the ability to take a completely hands-off approach to investing.
When considering target date funds, it’s important to take into account a variety of factors. Consider this your crash course in this type of fund. Here’s what you need to know.
What Are Target Date Funds (and How Do You Choose One)?
First, a little background information on target date funds. Target date funds are also known as life-cycle funds. They’re often mutual funds that hold a mix of stocks, bonds, and other investments.
How aggressive they are in terms of investments is determined by the time frame selected by the investor. As their name suggests, target date funds are designed to be long-term investments for certain future target retirement dates.
The name of the fund often describes its “target date.” For example, someone expecting to retire in 2055 might choose a fund called a “Retirement Fund 2050” or a “Target 2060.” (You don’t have to choose the exact year you plan to retire in — instead, you can choose it based on how aggressive you want to be with your investments.)
If this person invested in the year 2000 with a target date of 2050, their initial fund would be heavily invested in stocks and much less in bonds. Over time, the fund becomes more conservative to reflect the target retirement date. As the target date approaches, the fund automatically re-balances away from stocks and more towards bonds.
Pros of Target Date Funds
One of the biggest pros to target date funds is simplification. For many people, having a simple investment plan without much interaction is preferable to an investment plan that requires regular checkups and balancing.
Those who prefer a more hands-off approach may appreciate that target date funds offer the ability to take a more aggressive stance in the market while the individual is young and has more time to weather the ups and downs of the stock market. Over time, the fund is automatically re-balanced to reflect the retirement schedule of the individual, making it more conservative so it will retain its value and not be subject to stocks’ volatility.
Another pro for target date funds is the ability to remove the emotional aspect of investing. For some, choosing stocks is an emotional choice, based on many individual factors. Again, with a target date fund, investing and re-balancing is done automatically which helps remove the irrational decision-making from the equation.
Be Aware of the Drawbacks
Target date funds are not necessarily for everyone. One downside to target date funds is the lack of customization.
Target date funds don’t take into account an individual’s life changes that may affect their ability to save or the impact certain life events may have on an individual’s retirement plans. Someone who chooses a target date fund with a later retirement date, but who ends up retiring much sooner, may have a mix of funds that is too volatile for their new lifestyle.
Another drawback is the sheer number of target date funds from which to choose. While target date funds are similarly designed, they offer different approaches to investing based on your future retirement goals. Furthermore, some funds are more aggressive in the later years, with more allocation to stocks than bonds, while others get more conservative.
It’s important to do some homework when choosing target date funds, as their strategies can differ from your expectations for retirement.
Who Should Use a Target Date Fund?
In general, there’s no one specific type of person who should use target date funds. However, you may want to consider them if you fall into the following categories:
- Prefer a hands-off approach to investing
- Want to follow a traditional path in investing (aggressive allocation while you’re young, conservative investing as you approach retirement)
- Have a diversified investment strategy (i.e. you’re not relying on this fund to provide you with all your future income)
If you keep an eye on your investments, are realistic about your future, and plan on having a few different income streams in retirement, a target date fund may be an investment you want to consider.
Before choosing a target date fund, do some research on the investment company, expense ratios, and how the target date fund is rebalanced throughout the years. Target date funds can be good choices for many people, but as with all other investments, they do require an upfront investment of time to determine the best strategy for you.