What is a Target Date Fund?

Target Date Fund

You are considering your 401k options as a new employee or looking to increase and diversify your investment contributions this year. You see “Target Date Funds” as an investment option through the asset manager’s list of approved investment options. In some instances, maybe it’s your only option so it’s important that you understand what you are investing in.

What is a Target Date Fund?

A Target Date Fund is usually a mutual fund that provides an age-based approach to allocation mix and risk tolerance. Typically, the mix becomes more conservative as the target date approaches. These types of funds are extremely popular with 401k investors.

Target Date Funds can either be mutual funds or ETFs. They are named by the year in which the investor plans on using the assets.

Aside from coinciding with retirement age, these types of funds are increasingly being used by investors to match a future expense, such as the cost of a child’s tuition.

These funds are intended to be simple. Investors do not need to choose several investments to create a portfolio that will help them reach their retirement goals. Simply choose a single target-date fund to match your desired time horizon.

EXAMPLE

What is the purpose of this type of fund?

Stated simply, a target date fund is an investment vehicle used to manage investment risk over a long-time horizon.

The fund is consistently rebalanced over time by asset managers. Rebalancing typically takes place annually. The rebalancing provides for greater diversification and prevents a handful of stocks or sectors from growing disproportionately to other fund constituents.

Investors who allocate to this type of fund are comfortable taking a hands-off approach.

How does it work?

You pick a fund with a target year that is closest to the year you anticipate retiring.

Say you would like to clock out of the game in 35 years. If you purchased the fund today, in 2022, the fund would continue to evolve over the next 35 years and be called “XYZ 2057 Fund”.

Funds are managed by rebalancing asset class weights to optimize risk and returns. Initially, the fund is weighted toward higher performing, but speculative assets. Higher risk portfolios typically involve a mix of domestics and global equities. A lower risk portfolio may include fixed-income investments such as bonds and cash equivalents.

As you move toward your retirement “target date,” the fund gradually reduces risk by changing the investments within the fund. Therefore, in 2057, the fund would be composed of mostly fixed income, investment grade securities, maybe some dividend stocks, and cash.

Target Date Funds go by several common names:

Lifecycle Fund
Dynamic-Risk Fund
Age-Based Fund

What are the Disadvantages?

Any set-it and forget-it investment is going to come with disadvantages. A Target Date Fund does not provide flexibility. What if you want to retire early? And there is no guarantee that the fund’s earnings will keep up with inflation.

Target Date Funds can have expensive fees. As a “Fund of Funds” investment, investors will have to pay higher expense ratios on the underlying assets within the fund, as well as the fees of the target-date funds.

In some cases, investors may be lucky enough to be offered a no-load fund. But this is rare.

I always ask the question, “Why pay twice?” You are essentially paying 2x fees on index funds that you could buy and hold on your own. Or, alternatively, purchase through an ultra-low-cost manager like Vanguard.

Vanguard is still the industry standard here. Total Fees are around 0.16% for expenses. Vanguard is going to be using ultra-low-cost index funds. Competitors that employ active management strategies typically charge in the range of 0.75% for their expense fees.

Additionally, there is no “standard” vintage. What I mean by that is that the assets of funds with identical target dates will not hold the same investments in the fund.

Therefore, not all funds are created equal – even though they may have the same vintage. Make sure to do your homework when exploring your options; due diligence is still required in investing in Target Date Funds. It is critical that you understand the fund’s portfolio of assets.

* A Fund of Funds is an investment vehicle that invests in other mutual or exchange traded funds. By way of example, many hedge funds employ this style of investing.

The Target Date – What Happens at the End?

Nothing special happens when it reaches its target date. The fund doesn’t stop investing, and investors are not required to take money out of the fund. In general, the move from stocks to bonds simply continues. Target Retirement Funds are designed to keep you invested throughout your retirement years.

At the end of their investment lifecycle, funds are typically designed to provide income to retirees while seeking to preserve the original investment.