What Is a Target Date Fund?
The strategy of the fund will focus on capital appreciation at the beginning of the cycle and capital preservation as the target date approaches. The targeting is done through asset allocation, as the fund’s investments are shifted into less risky investments over time.
How a Target Date Fund Works (With Example)
Using the example of a 30-year-old investor who plans on retiring at age 65, the first phase of the fund’s asset allocation would focus on higher risk, more aggressive investments such as growth stocks.
After 10 years, the asset allocation will shift to more moderate investments that might include a mix of more conservative blue-chip stocks and high-quality fixed-income investments. As the investor nears retirement and the fund nears its target date, the investments will shift to an even more conservative mix with an even heavier weighting towards fixed-income investments.
Target date funds are also used extensively in 529 college savings plans. They are managed the same way as for a retirement fund. As the child ages, the investment style shifts from an aggressive stance, as it is when the child is relatively young, to a more conservative allocation as the child approaches college age.
Target Date Funds Pros and Cons
Target date funds have risen in popularity in recent decades as American retirement savings trends have evolved from defined benefit (pension plans) to defined contribution (401k). For inexperienced investors, target-date funds are a one-stop choice for all investment classes providing proper diversification, professional management, and convenience.
However, there are some disadvantages. Target date funds are often structured as a “fund of funds.” Mutual fund companies will bundle different funds from different asset classes into the target date fund product. This added layer of packaging, marketing, and administration can increase costs and eat into investment returns. And, the income or return from a target-date fund is not guaranteed. Market risk and inflation are always a factor.
Understanding Target Dates and Fees
The target date may be a useful starting point in selecting a fund, but should not be your only criteria. Consider the fund’s asset allocation over its entire lifespan, as well as the fund’s risk level, performance, and fees. You can find all of this information in the fund’s prospectus.
Some target-date funds may not reach their most conservative investment mix until 20 or 30 years after the target date, while others might reach theirs right at the target date. For example, a fund could hold 60% of its investments in stocks at the target date and 40% in bonds. The investment in stocks decreases until 25 years after the target date when it reaches an investment mix with 30% in stocks.
When considering fees, it’s important to pay close attention to the details. Often a target date fund invests in other mutual funds, and fees could be charged by both. Even small differences in fees can translate into large differences in returns over time.