When it comes to saving for retirement, one of the biggest hurdles you might face is figuring out what to invest in. Some investors prefer to build their own portfolios by hand-picking specific assets like stocks, bonds, and mutual funds. Other investors might opt to have someone else do it for them. A target date fund is an easy solution for someone who wants all the guesswork taken out of investing.
These funds are long-term investment options that can help you start saving for a future goal — like retirement — without having to build a portfolio or come up with your own investment strategy.
This article will explore target date funds, explaining their workings and helping you determine if this investment type suits your needs.
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- Target date funds are pre-built mini portfolios that make it easy to start saving for retirement.
- Over time, target date funds automatically rebalance to protect the value of your investment while giving you the opportunity to generate supplemental income.
- Target date funds are well-diversified and span a number of asset classes, mitigating risk
What is a target date fund?
Target date funds are portfolios designed around a specific financial goal, like retirement savings or funding a child’s education, and are defined by a specific timeline, or target date. The fund is specifically calibrated with your goal in mind and as time goes on, the fund’s asset allocation is automatically adjusted to protect the nest egg you’ve built for yourself.
Target date funds diversify investments by including various securities such as stocks, bonds, and mutual funds, rather than selecting individual assets. The mix of assets varies based on your personal risk tolerance and the date you expect the fund to mature. A 2070 target date fund could feature a greater stock allocation compared to a 2040 target date fund, for instance.
Aside from being a simple, ready-to-invest option, target date funds are popular because they are also well-diversified. Each target date fund consists of a number of different securities, spreading the fund's allocation across different assets. To manage risk, the fund gradually rebalances toward lower-risk assets like bonds and cash equivalents. While target date funds aren’t completely risk-free, they do make it easier for passive investors to mitigate risk.
How do target date funds work?
Think of a target date fund as a fund within a fund. It typically operates as a mutual fund that invests in other mutual funds. This simplifies diversification across various asset classes, as the fund is invested in hundreds of assets simultaneously.
Over time the target date fund rebalances to protect its value. Depending on the type of fund you choose and the purpose of the fund, it may shift from producing growth to generating supplemental income. That means in the beginning, the fund might be heavily invested in growth assets but later on, as it approaches the target date, it will shift to safer income-generating assets like bonds.
Passive management characterizes some target date funds, while others are actively overseen by a portfolio manager. A glide path determines the allocation of assets in a target date fund. This is a tool that anticipates risk exposure throughout the lifetime of the target date fund and helps portfolio managers adjust the fund’s asset allocation accordingly.
Structured like a mutual fund, a target date fund also imposes fees, akin to those of a mutual fund. The expense ratio, representing a percentage of your total investment, is termed the fee. Fees can vary across target date funds and may have higher fees based on who manages it. Fidelity’s Freedom 2060 Fund, for example, charges an expense ratio of 0.75%. While Vanguard’s Target Retirement 2060 Fund charges a 0.08% expense ratio. Understanding the fee structure of target date funds, in addition to the fund’s asset allocation, can help you ensure that you’re getting the highest return for your investment.
Types of target date funds
You have three main options for target date funds based on your goals and preferences: active, passive, and blended strategies.
A team of professional portfolio managers typically manages active funds. Using the fund’s glide path and stated objective, they’ll make selections to try to beat the market. Giving you the best return on your investment.
Passive funds are a way to invest on autopilot. Similar to mutual funds or exchange-traded funds, these types of target date funds usually track a major index like the S&P 500.
Instead of choosing one management style over another, some funds use a combination of both. A team manages these blended funds, selectively choosing how to execute trades to maximize returns for investors.
Aside from its management style, different target date funds align with specific savings goals. Retirement target date funds are the most popular. But you can also choose a target date fund for a different type of goal, like saving for a child’s future education. For example, Vanguard offers Target Enrollment Portfolios that you can invest in through a 529 college savings plan.
Other types of target date funds include “to” and “through” funds. This is especially important when it comes to choosing a fund for retirement. A “to” fund is usually designed to get you to retirement by utilizing a more conservative asset allocation. “Through” funds, on the other hand, continue to change the asset allocation of the target date fund holdings past your anticipated retirement date to continue generating returns.
Pros and cons of target date funds
While target date funds can make for a hands-off approach to planning for retirement, there are a few things to consider to make sure they are the right investment option that aligns with your goals.
Pros
- Well-diversified across different asset classes
- Automatically rebalance to mitigate risk
- Pre-built portfolio makes target funds an easy option for new investors to build retirement savings
Cons
- Funds may differ in their management approach, asset allocation, and the strategy employed for rebalancing.
- Some have higher expense ratios than others, eating away at your long-term returns
- While the funds tend to be conservative to protect your nest egg, they can result in missed opportunities to capture broader market growth
Tips for choosing a target date fund
When you’re choosing a target date fund, start by selecting one that aligns with your expected retirement date. If you have the option to invest in a target date fund through your employer-sponsored 401(k) and plan to retire when you’re 65, look for a target date fund that is closest to your expected retirement date.
You’ll also want to evaluate your personal risk tolerance. Some funds may have an asset allocation that is more conservative than you might prefer. While this can help your nest egg once you reach retirement, it can limit your growth potential early on. Review a fund’s asset allocation to make sure it aligns with your goals, risk tolerance, and expectations.
Decide on the management approach you prefer for the fund. Actively managed funds can help you try to beat the market but they’re not always successful. You may wind up paying higher fees with an actively managed fund but have similar results to a lower-cost passively managed fund. Be mindful of the structure of a target date fund to avoid incurring more losses than actual gains from it.
FAQs
Are target date funds good?
Target date funds can be good for new investors who are just starting to save for a big financial goal —like retirement. Or for investors who don’t want to hand-pick which assets to include in their portfolio. Since target date funds are pre-built, investors don't need to exert a lot of effort to create a well-diversified portfolio with the right asset allocation for their personal goals.
How risky are target date funds?
Target date funds aren't entirely without risk, but their design aims to mitigate it. The asset allocation usually includes low-risk assets, like bonds, and changes over time to protect the portfolio’s value. Investors can review a target date fund’s asset allocation on the portfolio manager’s website to learn more about the fund’s possible risk exposure.
Why would someone buy a target date fund?
There are a variety of reasons why someone might choose to buy a target date fund. They simplify the process of saving for retirement. Allowing investors to essentially save on autopilot. Due to their well-diversified nature, most target-date funds help mitigate the risk that investors might face when individually selecting assets for their portfolio.
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