Target Date Funds: Are They Right for New Investors?

Investing can feel overwhelming. There’s a lot of jargon, a lot of calculations, and a lot of uncertainty. Should you invest in stocks or bonds? A 401(k) or an IRA? Actively trade or buy and hold?

Target date funds (TDFs) are designed to make all that easier. They’re an auto-investing strategy based on when you want to retire: your “target date.”

Some investors think TDFs are too restricting, but for new investors or people who want to “set it and forget it,” they can be a good option.

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  • Target date funds are widely available in employer 401(k) plans and all major brokerages offer multiple TDFs.
  • With a TDF, you just set your retirement date and the fund automatically rebalances as you get older.
  • There is some criticism of TDFs, but for new investors or people who aren’t interested in personal finance, TDFs are a simple way to save for retirement.

. . .

What Are Target Date Funds?

If you’ve looked at the fund offerings in your 401(k) plan lately, you may have seen a proliferation of target date funds over the last few years. 

TDFs are a newer option. They were created in the early 1990s but became common in 2006 under the Pension Protection Act, which allowed companies to auto-enroll employees into their company 401(k) plans. 

TDFs were an easy way for 401(k) plan administrators to meet fiduciary requirements when automatically enrolling employees. 

But a TDF doesn’t just protect your plan administrator from regulator scrutiny — it also does some very good things for you as a new investor. 

With a TDF, you simply select the date you plan to retire (the target date), what your contribution rate will be, and… that’s it! You can go about your day while the plan automatically rebalances your account and slowly shifts to more conservative as you get older. 

READ MORE: How Much You Need to Retire

Source: FinancingLife.org

Criticism from the FIRE “Financial Independence, Retire Early” Crowd

 While TDFs escape the scrutiny of regulators, they don’t escape the scrutiny of everyone. 

When you hang out with investment-minded folks (i.e., FIRE folks and other money nerds), you will notice a common thread: Most of them don’t like TDFs. 

TDFs aren’t individualized 

This criticism is entirely valid. TDFs don’t get any more individualized than the 5- or 10-year period in which you hope to retire. 

It’s tongue-in-cheek described as the “orange prison jumpsuit” of investments. Which is maybe so, but you have to wear something.

TDFs aren’t optimized 

Again, this is valid. The most common TDFs are index funds and don’t adjust their holdings based on what the market may be doing on any particular day or week. And they don’t make adjustments based on where you find yourself in any particular market cycle.

How much those criticisms matter to you is open to discussion. 

For instance, if you’re 25 and investing your first dollars for retirement, just how individualized can you make a retirement plan anyway? Most people can’t figure out next week, month, or year, let alone plan four decades in the future. 

Similarly, just how optimized can you be? As much as I love the idea that you can get the most out of every dollar, it takes time, attention, experience, and knowledge that new investors just don’t have.

The truth is, most people just aren’t that interested in personal finance — and a lot who are aren’t that good at it. Research from Morningstar indicates that investors take a hefty annual penalty due to fidgeting in their portfolios.

Source: American Association of Individual Investors

TDF Advantages for New Investors

TDFs have some advantages that counter some of the worst errors people make when saving for retirement. 

Participation matters

The first common error that TDFs solve is simply doing nothing. 

According to the New York Federal Reserve, 35% of folks don’t participate in their employer’s retirement plan. Many people don’t know the difference between a stock and a bond or what a mutual fund is. 

But everyone understands retirement and approximately when they’d like to try it. A TDF is simply more approachable as an investment selection. 

When coupled with auto-enrollment, participation rates and savings rates go way up. While auto-enrollees can voluntarily unenroll anytime they’d like, they don’t in practice.

Don’t do something, just stand there

The second common error that TDFs solve is investors just being terrible at it. 

New and old investors alike generally fail to get the returns they should because they tend to tinker with their portfolios. They chase fads and trends, they buy high and sell low, they take too much risk or too little, they invest on emotions and headlines, and get dismal results. 

With a TDF, there’s nothing to tinker with or adjust — it’s a single fund around your retirement date.

In the words of Vanguard founder John Bogle, “Don’t do something, just stand there.”

READ MORE: Active vs. Passive Investing: Which Is Best?

How TDFs Make Saving for Retirement Easier

When I was in my early 20s at my very first job, I was offered a 401(k). 

During my onboarding, I was handed a single sheet of paper to sign up for the company plan. It listed the usual information from the plan administrator, a “fill in the blank” spot for the percentage of my paycheck I wanted to contribute, and roughly 15 different investment selections with a space to designate my asset allocation for each. None of them were TDFs since they hadn’t been invented yet. 

There was no information provided about any of the funds and neither the paper nor the HR person conducting the onboarding had any guidance. 

Six or seven of the 10 people in the onboarding just didn’t do anything. They didn’t sign up — leaving the company match on the table. The remainder all discussed at our next coffee break that we didn’t have a clue and hoped we hadn’t messed it up. 

The importance of what we were doing wasn’t reflected by anything in the process of doing it.

Worse yet, my experience was typical at the time for most new employees.

Changing with the times

It was that kind of experience that prompted the Pension Protection Act of 2006, the SECURE Act of 2019, and the SECURE 2.0 Act of 2022. 

Together, those laws make employee experiences better, easier, and less expensive. The 2006 law made auto-enrollment possible and the 2022 law made it mandatory for new plans. 

It also made plan administrators provide fiduciary advice to plan participants.

A modern-day example

I’ll compare the experience I had signing up for my first 401(k) with that of my son, also signing up for his first 401(k) in his early 20s. At his onboarding he was auto-enrolled in a TDF with a target date of 2070 — the date nearest his 67th birthday.

He was initially enrolled at a 5% contribution and his contributions will automatically increase by 1% per year until it reaches 10%. His employer provides a small match but a larger direct contribution of 5% to his account. 

He was provided a prospectus for the fund as well as an online class about saving for retirement, asset allocation, and savings rates. He also has access to an online planner that shows just how much he might be able to save and how relatively minor increases in saving could generate large differences in his funds at retirement.

While my son isn’t interested in personal finance at all, his onboarding and 401(k) elections give him a better than fighting chance at retirement — much more than my early experiences did. 

READ MORE: Where to Start Investing: Effective Money Growth for Beginners

FAQs

Are target date funds designed to be a stand-alone investment?

Yes, TDFs are designed to be a stand-alone investment. 

Holding other investments alongside a TDF negates the risk management aspect of the TDF, since it changes the asset allocation of the overall portfolio. It also negates the TDF’s simplicity by requiring periodic rebalancing and managing multiple investments. 

TDFs are designed to be widely diversified and risk-managed in a single investment.

Are target date funds suitable for all account types?

TDFs are primarily designed for tax-advantaged accounts like 401(k)s, IRAs, 529s, and HSAs. 

While nothing is preventing you from holding a TDF in a standard taxable brokerage account, rebalancing of the underlying funds can trigger tax consequences through capital gains. While rare, it’s not without precedent. 

In 2022, Vanguard TDFs generated 15.1% capital gains through a structural change at Vanguard. Many investors who held these funds in taxable accounts faced significant tax liability. But investors who held these funds in tax-advantaged accounts were unaffected. 

TL;DR: Should New Investors Consider TDFs? 

TDFs are a new option in retirement investing — and much needed over what was available not long ago. 

As the U.S. transitioned from a defined benefit (aka pension) to a defined contribution (aka 401(k), IRA) system, the products available needed to change, too. They needed to provide greater value to investors not only in terms of cost, diversification, and returns but also in usability. 

TDFs are an easy-to-understand way for new investors to get market returns and manage risk.

For more tips on managing your investments and saving for retirement, check out these episodes of the Erika Taught Me podcast:

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I'm an award-winning lawyer and personal finance expert featured in Inc. Magazine, CNBC, the Today Show, Business Insider and more. My mission is to make personal finance accessible for everyone. As the largest financial influencer in the world, I'm connected to a community of over 20 million followers across TikTok, Instagram, YouTube, Facebook and Twitter. I'm also the host of the podcast Erika Taught Me. You might recognize me from my viral tagline, "I read the fine print so you don't have to!"

I'm a graduate of Georgetown Law, where I founded the Georgetown Law Entrepreneurship Club, and the University of Notre Dame. I discovered my passion for personal finance after realizing I was drowning in over $200,000 of student debt and needed to take action-ultimately paying off my student loans in under 2 years. I then spent years as a corporate lawyer representing Fortune 500 companies, but I quit because I realized I wanted to have an impact; I wanted to help real people and teach them that you can create a financial future for yourself.

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Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. Terms apply to American Express benefits and offers. Enrollment may be required for select American Express benefits and offers. Visit americanexpress.com to learn more.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. Terms apply to American Express benefits and offers. Enrollment may be required for select American Express benefits and offers. Visit americanexpress.com to learn more.