The Pros and Cons of Target-Date Funds
Should You Invest in Target-Date Retirement Funds?
Target-date retirement mutual funds can work well for some investors but only if they are used properly.
Are you unsure of a proper asset allocation to reach your goals? Do you feel overwhelmed by thousands upon thousands of investment options? You can buy mutual funds, closed-end funds, and/or ETFs, but which fund types are right for you? Target-date mutual funds were created to help you make these decisions and ultimately simplify your life.
But are they right for you?
What Are Target-Date Funds?
Target-date funds are often thought of as "set it and forget it" funds. For example, if you plan to retire in 20 years, you might buy a target-date fund that matches your time frame -- that is, a target of 20 years. As you approach your retirement date, the fund moves its allocation to more conservative mutual fund investments (holding bonds and cash) and away from riskier mutual fund investments (holding equities). As the theory goes, set the investment in the fund and forget it - let the fund do all the work.
The reallocation over a predetermined period to reflect investors' changing tolerance for risk is known as the target-date fund's glide path. The glide path sets the fund's allocation among various asset classes over time, adjusting the mix from more aggressive investments early in the life of the fund to more conservative investments as the fund matures and investors approach their targeted goal.
Target-Date Funds -- A Popular Investment Option in Retirement Plans
A study in late 2008 by Deloitte and the Investment Company Institute showed that 72% of defined contribution plans (e.g., 401k plans) offered target-date funds. The popularity of target-date funds was sparked by the Pension Protection Act signed by President Bush in 2006.
As part of the Act, target-date funds became a "default option" of 401(k) plans that had an automatic enrollment feature. In other words, some employees are automatically enrolled in their 401(k) plans and their contributions automatically are invested in a target-date fund, like it or not.
Advantages of Target-Date Funds
Target-date funds can be useful if you are either starved for time or do not want to deal with making ongoing investment decisions. Several advantages of target-date funds include:
- Low minimum investments, allowing for instant diversification among various asset classes (equities, bonds, etc.)
- Professionally managed portfolios, offering a hassle-free investment
- Low maintenance, as the funds are designed as a one-size-fits-all solution
Disadvantages of Target-Date Funds
While there are advantages of target-date funds, investors should also be aware of the pitfalls. Issues to consider include:
- One size fits all - Does it? A correct investment mix for one person is not necessarily correct for everyone.
- Higher expense ratios - In some target-date funds, there is a fee for the underlying mutual funds and another layer of fees for managing the funds.
- Lack of diversification - If the target-date fund invests only in funds from one particular fund family (Fidelity, Vanguard, etc.), this can lead to a similar investment style across the underlying mutual funds.
Next Steps for Choosing a Target-Date Fund
If you are captivated by the idea of simple and disciplined investing via target-date funds, the next step is to research the options. There are many target-date funds. In fact, several low-cost providers offer a multitude of target-date funds, including T.Rowe Price, Vanguard, and Fidelity.
Updated April 28, 2016, by Kent Thune.