Target date funds are mutual funds and ETFs which adjust their investment allocations between stocks, bonds, money market and other assets based on the fund’s stated target date. They have received a ton of negative press recently which we feel is due to a misunderstanding of how these funds work and who they are designed for.
How Target Date Funds Work
Investors choose funds with target dates that are close to the year they plan to retire. Target date funds tend to have many different types of assets in the funds, including US Stocks, International Stocks, US bonds & money-market type investments. The secret sauce of target date funds is how they allocate funds to each asset type.
Although the allocation process will differ depending on which target date fund you choose, they should all follow a similar pattern: as the fund moves closer to and eventually past its target date, its investments will become increasingly more conservative. For example, a fund with a target date of 2050 will likely have a much larger percentage of its portfolio in riskier assets like stocks, than the same type of fund with a 2020 target date. Below are two screenshots from Fidelity’s website showing how the asset allocation in their 2050 target date fund will look in the year 2020 vs. the year 2045.
Fidelity’s 2050 Target Date Fund Allocation in the Year 2020
Fidelity’s 2050 Target Date Fund Allocation in the Year 2040
The target date of the fund is not meant to be the end date of the fund (where all the money is paid out to investors) but rather the retirement year of the investor of the fund. In most target date funds the fund manager will continue to make changes to the allocations in the portfolio after the target date for several years before shifting into income generating investments only.
The Advantages of Target Date Funds
- Simplicity: Its easy for individual investors to get overwhelmed with all of the different investment options out there. The goal of target date funds is to simplify the investing process with one fund designed for retirement saving, that automatically adjusts for you as you age.
- Diversification: Target date funds provide you with the diversification of a normal mutual fund + the added diversification benefits that come with investing in different asset classes (both stocks and bonds for example).
- Designed for the Long Term: Target date funds are by definition designed to be long term investments. While you can sell most target date funds at any time, their “set it and forget it” style makes investors less likely to allow short term market fluctuations to adversely affect their investment decisions.
The Disadvantages of Target Date Funds
- You Still Have to do Some Research: Different firms manage their target date funds differently. A target date fund from Fidelity is not going to be the exact same as a target date fund from Vanguard. They will have a different mix of assets, and even when investing in the same asset class, make different choices of how to invest in the asset class. Some firms will also have different funds with the same target date, which adjust allocations more aggressively or conservatively. While this is often cited as a disadvantage of target date funds, I view the availability of some different variations within the same broad theme positively. The bottom line however is you still need to be aware of what your risk tolerance is, and how the fund you are considering may perform under different market scenarios, before making an investment.
- Less flexibility: Target date funds are designed to accommodate the general investing needs of a broad group of individuals and not for your exact situation. The more “special” your specific situation is, the less likely target date funds are going to be a good option for you.
At a minimum target date funds are a great starting point
A dynamic mix of stocks and bonds which adjusts based on your age is likely going to be needed when saving for retirement, regardless of your specific situation. Target date funds are a good place to at least start your research, so you can get an idea of what “standard” allocations look like. If you don’t like what you see, then you can decide which parts of the “standard” you would like to tweak, and go about choosing normal mutual funds or other investments which better fit your situation.
As a general rule, the further you are away from retirement, the lower your income, and the smaller your portfolio, the more likely target date funds are to be a good option for you. The closer you are to retirement, the higher your income, and the larger your portfolio, the more likely you are going to benefit from a more personalized approach.
Here is a list of some of the more popular target date fund providers:
T. Rowe Price