Target-date funds are popular options for saving and investing for retirement, but popularity doesn’t mean they are the best option for everyone. To determine whether a target-date fund makes sense for you, it’s important to understand what they are, how they work and how they fit into your overall financial plan.
Below, we walk through the pros and cons of target-date funds so you can be better equipped to make a decision about your finances.
What is a target-date fund?
A target-date fund is a fund optimized to help grow an investor’s money over a given period of time. The period of time is when you invest in the fund until the “target date,” when an investor intends to begin accessing those assets. As such, assets held in a target-date fund will automatically rebalance over time to become more conservative as the target-date approaches. These funds are technically a fund-of-funds, which invest in exchange-traded funds (ETFs) or mutual funds across asset classes.
Often, target-date funds are titled with the year an investor intends to retire, but they can also be used for other goals with a clear timeline, such as investing for a child’s future college education.
Target-date funds for retirement use either a “to” or “through” glidepath. So-called “to” glidepaths are designed for an investor who expects to invest in the fund up until retirement, while a “through” glide path is for the investor who plans to withdraw funds gradually in retirement.
How does investing in a target-date fund work?
To invest in a target-date fund, you'll want to know the year you intend to retire. You would then select the target-date fund that corresponds with that year and begin making contributions. Many retirement accounts, such as 401(k)s, already offer target-date funds.
For example, consider an individual who is 26 years old in 2021 and who intends to retire when they are 65 years old. That individual would select a 2060 target-date fund, as it corresponds with the year they will begin retirement withdrawals.
When contributions begin, the investor will most likely notice the fund’s asset allocation is heavily skewed toward stocks, which offer a greater opportunity for growth over the long term, but which also carry a higher level of risk.
As retirement grows closer, the fund will gradually become more conservative, typically by holding more bonds and cash. These holdings provide less opportunity for growth, but also carry less risk compared to stocks.
The pros and cons of target-date funds
Many investors like target-date funds because of their simplicity. Just pick a date and start investing. The funds offer instant diversification, both within and across asset classes, and because they are automatically adjusted and rebalanced over time as you approach retirement, they make an excellent option for the “set it and forget it” crowd.
While target-date funds are a popular, “easy” option, that doesn’t mean that they are well suited for everyone or without potential drawbacks.
For starters, target-date funds can be more expensive than other investment options, as you will need to pay fees not only for the target-date fund itself, but also for the different funds that it invests in. According to Morningstar, the average target-date fund charges total fees of approximately 0.59 percent (a little pricier than a passive index fund, but lower than an actively managed fund). Over time, those fees will impact the total return of your investments.
Additionally, target-date funds are, by their very nature, designed to be a “one size fits all” option. In reality, however, everyone’s financial goals and risk tolerance are different, and there is no guarantee a target-date fund will align with your circumstances.
Finally, target-date funds are typically meant to be an all-in-one investment strategy. If you hold investments in an individual retirement account (IRA) or personal brokerage account in addition to your target-date fund, you may find yourself overexposed to certain asset classes or individual investments. This is due to the fact that the target-date fund doesn’t consider the other investments you hold.
Should you invest in a target-date fund?
Ultimately, the answer to this question will depend on your personal investment style.
If you prefer to be hands-off and find that your risk tolerance aligns pretty closely with others your age, a target-date fund can be a good option for you.
On the other hand, if you want to be more hands on in choosing your investments, a target-date fund might not be the right option for you. Likewise, if you find your risk tolerance to be far outside the norm (one way or another) compared to others your age, you may find that a target-date fund doesn’t align with how you would like to manage your money.
It’s important to recognize that you have other options, as well. A financial planner or wealth manager can help you think about your money holistically, across all of your various accounts, in order to craft a financial plan that makes the most sense for your goals.
All investments carry some level of risk, including the potential loss of principal invested.