Definition and Example of a Target Date Fund
Target date funds are a type of mutual fund that becomes more conservative in its asset allocation over time as a future date approaches. A target date fund may also be referred to as a target date investment. Employers may offer these funds as an investment option in their 401(k) plan, but it is important to understand how they work before buying in. Learn whether target date funds could be a suitable way to simplify your portfolio.
How Does a Target Date Fund Work?
A target date fund works by adjusting its asset allocation over time based on its glide path. This is simply the investment strategy followed by the fund according to its target year. These funds are typically designed for long-term investment. They can contain a mix of stocks, bonds, and other securities. This allows the fund to achieve returns for investors while managing risk.
As the fund approaches its target date, the allocation shifts to reduce risk. This takes into account the reduced risk tolerance of an investor nearing retirement. Target date funds can be offered through workplace retirement plans such as 401(k) plans or taxable brokerage accounts. The choice of the right fund usually depends on the expected retirement date.
Suppose you are 25 years old and enrolling in your employer’s 401(k) plan. You have the option to invest in the Vanguard Target Retirement 2060 Fund (VTTSX), which is designed for people planning to retire between 2058 and 2062. This fund consists of about 90% stocks, with the remaining 10% distributed among bonds and short-term reserves.
Over time, the distributions of this fund will reduce your exposure to stocks and increase your exposure to bonds. Once the target date of the fund is reached, the distributions will continue to adjust for about seven years thereafter until they align with the distributions of the Vanguard Target Retirement Income Fund (VTINX). The income fund’s distributions are approximately 30% stocks and 70% bonds and short-term reserves.
This assumes that once you retire, you will be looking for income from your investments rather than growth. Compared to stocks, bonds carry less risk and trade more steadily.
Note: Using a retirement calculator can help you estimate what your target retirement year might be based on your investment goals.
Are Target Date Funds Worth It?
Investors may find the simplicity of target date funds appealing. It is sufficient for the investor to identify the year they plan to retire and then use that as a guide to choose the fund. The fund manager handles the rebalancing, so there is nothing you need to do other than continue investing in the fund. This can be ideal if you prefer a passive investment approach.
However, it is important to consider what you may pay for this convenience in terms of management fees and the type of returns you may achieve. Cost-wise, some target date funds can be very affordable. For example, the previously mentioned VTTSX fund has a low expense ratio of just 0.08%. This is well below the average expense ratio for hybrid funds that include stocks and bonds at 0.59%.
How do target date funds perform? It is difficult to estimate the historical performance of target date funds because many have not yet reached their target dates. One study suggests that investors in target date funds may face a hypothetical cumulative loss of up to 21% after holding the fund for 50 years due to poor performance and high fees.
Note:
Past performance of an investment fund does not guarantee future results.
One clear drawback of target date funds is that they are designed to be one-size-fits-all when every investor is different. If you invest in a target date fund that performs poorly, you may fail to meet your retirement goals. For this reason, you should consider the asset mix and glide path of the fund before investing to determine if it is right for you.
Key Takeaways
Target date funds are diversified investment funds that change their asset allocation over time to become more conservative. A target date fund, also known as a “target retirement fund,” is a popular option in 401(k) plans. Target date funds can help simplify the process of choosing the appropriate asset allocation, but may perform poorly. Investors should consider performance, risk profile, asset allocation, and management fees when selecting a target date fund.
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Sources:
Office of Investor Education and Advocacy. “Target Date Retirement Funds.”
Vanguard. “Vanguard Target Retirement 2060 Fund (VTTSX): Portfolio & Management.”
Vanguard. “Vanguard Target Retirement 2060 Fund (VTTSX): Overview.”
Vanguard. “Vanguard Target Retirement Income Fund (VTINX): Portfolio & Management.”
Vanguard. “Vanguard Target Retirement 2060 Fund (VTTSX): Fees & Minimums.”
Investment Company Institute. “Trends in the Expenses and Fees of Funds, 2020.” Page 1.
SSRN. “The Unintended Consequences of Investing for the Long Run: Evidence From the Target Date Funds.”
Source: https://www.thebalancemoney.com/what-is-a-life-cycle-fund-5219558
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