Takeaways
- Target date funds are typically structured as a mutual fund or fund of funds.
- Target date funds calibrate returns and risks to align with a specified retirement date.
- Target date funds appeal to investors because their investments run on autopilot.
- Target date funds automatically rebalance their holdings, making it an easy investment.
- Target date funds usually mature in 5-year increments (e.g., 2025, 2030, 2035).
Knowing where to invest your hard-earned money is often the first hurdle to investing for beginners. With so many investment options available, finding investments that offer new and seasoned investors opportunities to grow their money over time can take significant due diligence. Luckily, investment professionals have already done the heavy lifting and created diversified investment vehicles to help you make more money. One of those investments is a target date fund.
Target date funds can be excellent long-term investments to help you balance risk and reward as you establish your portfolio. Starting to invest can be one of the smartest money moves of your life. Investing can increase your financial flexibility, help you retire quickly, or achieve a specific financial goal. Ultimately, investing will help you better understand your finances.
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What Is a Target Date Fund?
Target date funds are pools of capital that invest to reach an anticipated retirement date. Target date funds are structured like mutual funds. Many target date funds are “funds of funds” which means that they are pools of capital that invest in many different mutual funds instead of investing in multiple securities.
Target date funds consist of investments in stocks, bonds, real estate, and other assets in a single fund to help investors plan for retirement. Target date funds are typically used for retirement planning because they calibrate their investment risk and gradually become more conservative over time, as the fund reaches the target date. This change in portfolio allocation is called a target date fund “glide path” and is designed to reduce risk as the fund date approaches.
This matches the shift in risk your portfolio should have according to investment professionals. Below is an example of how a retirement account’s asset allocation may evolve.
(Graph Provided by Schwab)
The idea is that while you are younger, your portfolio can absorb more risk as the fund seeks to generate higher investment returns. However, as you approach retirement, your investment mix should rebalance to become more conservative. Target date funds are popular investments for retirement planning because it takes the guesswork out of what investments to make and when.
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Target date funds with the same target date are not necessarily the same. Each fund will have different investment strategies and asset allocations. Make sure you read the target date funds holdings to ensure they align with your overall retirement portfolio and financial goals.
5 Advantages to Target Date Funds
Target date funds try to solve a high-level problem by providing an investment vehicle that automatically adjusts its allocation during an investment term. Successfully saving for retirement can be accomplished by taking advantage of the benefits of target date funds.
Here are five critical advantages to investing in target date funds:
1. Diversification
At their core, some of the best target date funds provide tremendously broad exposure to thousands of domestic and international stocks, bonds, and other investments. Diversification gives you access to investments you would not be able to reach at the low costs associated with target date funds.
This diversification makes target date funds compelling for retirement accounts, which provide a haven for your nest egg.
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2. Professional Management
Target date funds offer investors access to professional management. These investment professionals construct a portfolio allocation strategy for the fund which aims to generate returns, mitigate investment risk, protect against inflation, and rebalance at the appropriate time points to progress toward a more conservative mix over time.
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3. Automatic Rebalancing
Your fund composition is actively managed to ensure that the proper allocation of asset classes represents how close or far away you are from your “target date”. Automatic rebalancing in parallel with diversification provides a dual strategy to ensure you get the proper investment risk that aligns with your risk appetite.
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4. Low Costs
A high fund expense ratio can eat into your overall investment returns, reducing the gains you should enjoy from a successful investing strategy.
Smart Tip:
Expense ratios are the fees associated with managing the fund and typically include expenses such as portfolio management administration, marketing, distribution, and other ancillary costs. Expense ratios are a percentage of the fund’s average net assets.
Target date funds have low expense ratios. This can put a meaningful amount of money back into your account. Over time, these low expense ratios will keep more of your money in your account.
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5. Default Retirement Investment
Target date funds have become one of the default investments for retirement accounts because of all their benefits. If you can participate in an employer-sponsored retirement plan, the à la carte menu of retirement options your plan offers probably involves a curated list of target date funds.
To choose the right target date fund, it needs to align with your overall retirement goals. You can invest in target date funds through your online brokerage account or with a Roth IRA or Traditional IRA.
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How to Invest in a Target Date Fund
Target date funds, also called lifecycle funds, are designed to simplify investing for retirement. Choosing a fund whose glide path matches your risk profile and determining how much to invest in the fund are both important considerations. But there are other factors to determine the best target date fund for your portfolio. Here are five steps to take to invest in a target date fund:
Choose Your Target Date
The first step in wanting to invest in a target date fund is to pick your fund. This process is easy by design. All you need to do is answer the question: When do you want to retire? If you are 25 years old and want to retire in 30 years, you select a target date fund with a date 30 years in the future. Similarly, if you are 40 years old and want to retire in 20 years, choose a target date with a date 20 years into the future.
Align Your Risk Profile
Target date funds can be the backbone of your retirement portfolio, or they can be part of the supporting cast. Because not all funds with the same target date are the same, you will need to investigate the fund’s investment strategy and select the fund that matches the risk level you need for your whole retirement portfolio. If your target date fund is your retirement portfolio, choose a fund that matches your risk appetite.
“To” or “Through” Retirement
As with all investments, conducting your due diligence before investing is critical. Some target date funds have dates designed to carry you “to retirement”, while others are structured to take you “through retirement”. A fund that carries you “to retirement” will reach peak conservatism (fewer investments in stocks and equity holdings) at the target date and generally not change afterward. However, “through retirement” funds reach maximal conservatism after the target date. Many funds shift to investments that generate income after the retirement date.
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Make Your Investment
Once you have selected the right asset allocation, target date, and glide path that aligns with your overall retirement goals, it is time to invest in a target date fund. Many employee-sponsored 401(k) plans have a buffet of target date options. However, if you don’t have a 401(k) plan, you can also invest in target date funds through your Roth IRA, Traditional IRA, or online brokerage account.
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Monitor Your Glide Path
How a fund shifts its investments across asset classes is called a glide path. This path is created to have riskier investments in the early years and gradually become more conservative over time. However, a fund glide path and asset allocation can change over time. Regularly monitoring your glide path will ensure there are no surprises. If the fund strategy does change significantly or does not align with your overall portfolio, you can consider making alternative investments.
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Smart Tip:
If you want to retire before 65, selecting an earlier target date (say 2040) will not help you reach retirement faster. It would be counterproductive. Because the fund will become more conservative earlier, your investments will not have the opportunity to earn a higher return in the earlier years of the fund and shift to becoming more conservative too soon.
Are Target Date Funds Diversified?
Investment diversification is a strategy that involves investing across different asset classes. Diversification helps your portfolio in both bull and bear markets. A diversified portfolio may invest in stocks, bonds, cash equivalents, and real estate, and in any one year, one of these asset classes may have a good or bad year, offsetting each other.
Diversification is essentially the process of not putting all your money into one investment. If you invest all your money in one stock and that company performs terribly, your investment may be worth nothing. Instead, a diversified approach spreads your money around to avoid single-stock risk.
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Because target date funds invest in many assets to spread risk and return, they are considered highly diversified investments. In the early years of a target date funds life, they heavily invested in assets that generate a high rate of return and rebalance over time to reduce risk while simultaneously increasing certainty.
Smart Summary
Investing for retirement is a smart money move. Target date funds have become incredibly popular retirement saving vehicles because of their automatic glide paths, easy-to-understand investment strategies, and set-it-and-forget type of investment approach. Many 401(k) plans and Individual Retirement Accounts offer fantastic optionality when it comes to selecting your target date and risk profile. A target date fund can be a quiver in your retirement approach or provide the backbone of your overall investment strategy. Consult with a financial advisor and regularly monitor your financial goals to ensure your retirement portfolio is on track.
Frequently Asked Questions
Yes. Anyone with an online brokerage account or retirement account can invest in target date funds.
Target date funds give you access to professionally managed accounts that actively work to reduce investment risk as retirement savers approach retirement. Target date funds offer low-cost solutions for many retirement savers seeking broad diversification.
You can invest in target date funds through your online brokerage account or an employer-sponsored 401(k) retirement account.
