When you’re managing money and creating a plan for the future, there are multiple factors to consider. You have to determine which of your goals are most important to you, how comfortable you are with financial risks, and how much time you have to reach certain objectives. The more detailed your plan is, the better chance you have of being satisfied with the outcomes.
That said, custom financial plans require regular maintenance, so some investors leverage what’s called a target date fund to establish a simpler retirement investment plan. In this blog, we’re discussing how these funds work and what you should know before using one.
What is a Target Date Fund?
A target date fund (TDF) is designed to be a “set it and forget it” approach to investing for retirement accounts. They’re meant to be more aggressive (with the chance of earning greater returns) when an investor is younger, and less aggressive as the investor gets older and closer to his or her retirement date. This usually means the fund’s asset allocation shifts from more stocks (and fewer fixed income sources) to more fixed income sources (and fewer stocks) over time. This gradual shift in asset allocation is called the TDF’s glide path.
A TDF is typically set up as a mutual fund that decreases its overall risk as the fund approaches its target date, or “retirement year,” which theoretically corresponds to the investor’s retirement year. For this reason, they’re sometimes called age-based funds or lifecycle funds. They’re usually offered via 401(k)s or other types of retirement plans, but you can also purchase them as part of brokerage accounts or IRAs.
Are all TDFs the same?
Despite their common goal, all target date funds are not created equal. Different fund managers and companies manage TDFs in different ways; consequently, even TDFs with the same target year follow different glide paths. For example, one fund manager might manage a Target 2025 fund with the assumption that an investor’s stock-bond ration should be 40/60 at retirement, while a different fund manager might aim for a stock-bond ratio of 30/70 at retirement.
In 2008, some investors experienced the harsh reality of this when their Target 2010 funds lost more than 40 percent just two years before retirement. Investors expected their ready-made funds to perform like other 2010 target date funds, but because some fund managers had vastly different investment styles, some investors remained “safe” while others lost big time – despite them having portfolios with similar goals.
As such, there’s really no “standard” or precise method to managing a target date fund—which is why it’s incredibly important for an investor to understand what their individual plan looks like. Then they can determine if their TDF aligns with their goals and risk tolerance.
What are some pros and cons to using a Target Date Fund?
Aside from “looking under the hood” and making sure you choose a TDF whose allocation is consistent with your risk tolerance (as described above), target date funds require minimal ongoing maintenance on the investor side, which is great for DIYers who want something simple. By nature, TDFs are reasonably diversified portfolios, so there’s no need to regularly rebalance one on your own or worry about asset allocation.
On the downside, TDFs lack transparency about their underlying investments; it’s difficult to know exactly what you’re investing in without going through the fund’s prospectus or looking at the annual report. A target date fund also assumes its investors are retiring in its designated target year, even though individual investors may not actually retire that year. (For example, someone may have a 2030 TDF but plan to retire in 2027.) TDFs also don’t account for individual risk tolerance, income needs, or an investor’s overall financial situation, which makes it difficult to synchronize a TDF with a comprehensive investment strategy. Like mutual funds, generally, target date funds involve a risk of loss. They are subject to the same risks as the underlying stocks and bonds they hold.
What do I need to know before investing in a Target Date Fund?
If you’re considering a TDF, do your research and consider what your appetite for risk is. Remember, just because the retirement year of the fund aligns with yours, that doesn’t mean the asset allocation matches your risk tolerance or individual goals. Find out what a TDF is investing in before you invest your own money. Ask your advisor for help doing the research; if you decide a particular TDF is too risky, your advisor should be able to present another solution.
For more complete information about any target date fund, please request a prospectus from your registered representative. The prospectus explains the investment objectives, strategies, risks, charges and expenses of the fund and should be read carefully before investing.
The Bottom Line
Even though target date funds are designed to grow with you, that doesn’t mean the specifics of any given fund will actually align with your goals or risk tolerance. So whether you already have a TDF or you’re considering one, do your due diligence to better understand what’s under the hood. If you purchase one through your 401(k), you can reach out to the 401(k) provider, the advisor on the 401(k), or your personal financial advisor for help with the research and decision-making process. If you’re purchasing a TDF outside an employer plan, we highly recommend talking with your advisor.
If you don’t have an advisor and you want help with your financial strategies, just give us a call or send us an email! We’d love to answer your questions and get you on track to achieving your goals.
This article is intended to be for general information about the topic(s) described only, and should not be used as financial advice specific to your situation. For financial advice pertinent to your lifestyle, goals, risk tolerance and opportunities, please contact a financial professional.