If you’re new to the world of investing, it can be easy to get overwhelmed with the options available. Investment vehicles like stocks, bonds, mutual funds, certificates of deposit, exchange-traded funds, and annuities are just some of the categories to consider.
With so many choices, where should a first-time investor begin?
Target-date funds (TDFs) were created to take as much guesswork out of investing as possible, making them a popular choice for new investors. Like any investment, however, target-date funds have pros and cons that must be considered.
So What Exactly is a Target Date Fund?
Target-date funds were structured to be a set-it-and-forget-it type of investment vehicle. The funds are structured with a future date of when you will need the money (say, retirement), hence the name “target-date” funds.
The funds themselves are designed to contain a mix of investment vehicles. They include equities (stocks) and fixed income (bonds) that rebalance the closer you get to the target date.
The further you are away from the target date, the more aggressive the funds will be to maximize potential growth in the market. This means that the funds will contain a higher mix of equities early on. As you approach the target date, the fund will automatically rebalance to include more fixed income to protect the earnings you’ve gained while still growing the account.
For example, if you’re 30 years old and are saving for retirement, a target-date fund might contain 85% stocks and 15% bonds. When you’re 55 years old, this same fund might have been rebalanced only to contain 30% stocks and 70% bonds. Different providers will offer a more sophisticated range of strategies and mixes.
In short, target-date funds:
- Provide a simple way to prepare for retirement without having to be hands-on
- Offer exposure to both equities and fixed income with different asset allocation options
- Rebalance overtime to protect your earnings the closer you are to retirement
Of course, nothing is ever as simple as it seems. There are still pros and cons to consider when it comes to target-date funds.
Benefits of Target Date Funds Explained
Traditionally, investors with a 401(K) had to choose several investments to create a retirement portfolio. In other words, investors traditionally had to decide what types of stocks and CDs to put into their own 401(K) account.
Target-date funds, on the other hand, mitigate the need for other assets. These funds include a mix of stocks and fixed income securities. Because the fund automatically rebalances over time, it can feel like a one-and-done approach. All you have to keep doing is investing in the account every month. After you’ve picked a fund, it rebalances as you approach the target date, so it requires little to no management from you.
Availability of Choice
Even though target-date funds were designed to be simple, there are still a variety of options to choose from. For example, you can select a fund based on your risk tolerance: conservative, moderate, or aggressive. In general, the higher the risk, the higher the reward. Like any other investment, however, the market’s past performance is no indication of future returns.
But even with the aggressive option, target-date funds always include fixed income securities, which provide an innate level of protection against losses.
Passive and Active Management Options
If a set-it-and-forget-it investment strategy sounds too hands-off, you can find target-date funds that feature either active or passive management.
Active management features a human element, such as a single manager or a team of managers. These investors actively manage the portfolio on your behalf. It will still be relatively hands-off on your end. Still, you can rest with peace of mind knowing that financial experts handle analytical research, forecasts, and their own experience in making investment decisions for you.
Passive management, on the other hand, mirrors the market index. Instead of a team of investors attempting to beat the market, the passive target-date fund utilizes weighted average mathematics to reflect the market as closely as possible.
To recap, the key benefits of target-date funds include:
- Simplicity for first-time investors
- Ability to choose funds based on risk tolerance
- Active and passive management options
What are the Downsides of Target Date Funds?
Fees Can Eat Away at Your Earnings
To make money investing, your earnings must outweigh the costs you spend on fees. Since a target date fund is inherently composed of multiple funds, it’s easy for these fees to add up. It’s not uncommon for these fees to add up to 1% or, in some cases, even up to 2%. This means that if the target date fund earns 8% every year, you will only see 6% or 7% of the actual earnings.
Lack of Flexibility
Target date funds are set for a specific date in the future, but what happens if you want to retire earlier than you planned? Or if you’re going to keep working a few years beyond that target date? Unlike other investments that can be quickly modified to address these needs, target-date funds are beholden to that future date. Also, because the funds are generally more conservative than equities, there is no guarantee that the fund will keep up with inflation.
Some Companies Offer Little Diversification
There are some companies where the funds within the target portfolio are all offered by the same company. These are known as “single fund families.” While there’s nothing inherently wrong with investing in the same company, it may not be the wisest choice to put all your eggs in one basket.
They Typically Underperform Other Investment Vehicles
A set-it-and-forget-it approach to retirement is undoubtedly nice, but that comes at the expense of risk and reward. Growth stock mutual funds, for example, focus on stocks of companies that are expected to grow at a faster rate than the rest of the market. These typically outperform target-date funds, but still offer protection by diversifying in multiple businesses.
To recap, the downsides of target-date funds include:
- High fees that can eat away at investment earnings
- Lack of flexibility
- Some TDFs only include underlying funds from 1 company
- Underperform other investment vehicles
Are Target Date Funds Right for Me?
If you’re looking for an easy, hands-off approach to investing and preparing for retirement, a target-date fund may be right for you! Investing isn’t a one-size-fits-all journey, so determining whether this is your best option will require some introspection.
Target date funds aren’t the worst way to invest your money, but they aren’t going to provide high-risk, high-reward. Many consider it a safe bet for new investors, but you should still research and consider other options.
Unless you’re willing to hire a financial advisor to help you allocate and actively manage your investments, a target-date fund may be right. Because the fund itself automatically rebalances the closer you get to retirement, you will enjoy the peace of mind knowing that your investments will be protected as much as possible while still providing a steady income stream to your account. However, this comes at the expense of higher fees and lower returns than a self-created portfolio or growth stock mutual fund.
Ask yourself the following questions:
What is my tolerance for risk?
If you have a low to mid-level risk tolerance, then target-date funds are likely a solid choice. However, if you want a higher risk with higher rewards, you may want to consider another option.
Do I want to modify the plan?
Again, as the name suggests, the target-date fund is designed with a specific future date in mind. If you can commit to that date, then a target-date fund is a great choice, assuming you accept that you cannot modify the plan moving forward.
Am I comfortable with the fees and expenses?
Every investment vehicle will have costs of some sort. Make sure that you understand the costs of anything that you invest in. This is true with whether or not you invest in a target-date fund or something else.
The Bottom Line
When it comes to investing, there are a vast amount of options. If you're wanting to invest, be sure to do your research and list out the pros and cons of each so you can find exactly what you're looking for.
I hope this guide has helped you understand the pros and cons of target-date funds! There is a no-size-fits-all solution, so continue to ask yourself what’s important to you.