What Are Target-Date Funds?

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DEFINITION

A target-date fund is a type of investment that becomes more conservative as the investor’s target retirement date approaches.

Definition and Example of Target-Date Funds

A target-date fund is a mutual fund that automatically rebalances its asset allocation to become more conservative as it gets closer to the investor’s target date—the estimated year when the investor will retire.

One example of a target-date fund is Vanguard’s Target Retirement 2065 Fund (VLXVX). It’s intended for people who expect to retire between 2063 and 2067. The fund starts with a high percentage of stocks, and will gradually sell its stocks and buy more bonds and TIPS funds as the 2065 target date approaches.

How Do Target-Date Funds Work?

Target-date funds are designed to provide investors with a diversified portfolio that automatically becomes more conservative as their target retirement date approaches.

Target-date funds are often used in employer-sponsored retirement plans such as 401(k)s. However, you may also be able to find them inside your taxable brokerage account.

You typically choose a target-date fund that correlates with the year you plan to retire. For instance, if you plan on retiring in 2065, you’d choose a target-date fund with “2065” in its name. If you planned on retiring in 2040, you’d choose one that says “2040.”

Most target-date funds come in five-year increments (e.g., 2040, 2045, 2050). If you’re retiring in a year that doesn’t end in a “0” or “5” (such as 2043), you could choose a 2040 fund if you have a lower risk tolerance or a 2045 fund if you have a higher risk tolerance. Or you could split the difference and invest in both.

Target-date funds typically start out with a relatively aggressive asset allocation made up of mostly stocks and stock equivalents. The mix of assets gradually becomes more moderate as the target date approaches. This is because the closer you get to retirement, the less time there is to recover from market setbacks.

Glide Paths

This shift from “aggressive assets” to “conservative assets” is known as the target-date fund’s glide path. Some target-date funds have glide paths that go “to retirement,” while others go “through retirement.”

  • “To retirement” target-date funds reach their most conservative asset allocation at the target retirement date. The moment that date hits, your fund is as conservative as it’s going to get, and it won’t change again.
  • “Through retirement” target-date funds reach their most conservative asset allocation a few years after your target retirement date. They give your money a few more years to grow and compound before they taper off.

This distinction means that even if two funds have identical target years, they could have different asset mixes depending on their glide paths.

Some target-date funds will also “merge” into other funds as they reach their target date. For example, Vanguard’s Target Retirement 2065 Fund (VLXVX) mimics Vanguard’s Target Retirement Income Fund within seven years after 2065.

Fund Fees

Fees such as expense ratios, or an amount you pay each year to hold the fund, can also vary significantly from one target-date fund to another. Let’s compare three funds with different expense ratios:

  • Vanguard Target Retirement 2065 Fund (VLXVX): 0.08%
  • T. Rowe Price Target 2065 Fund (RPFDX): 0.46%
  • Fidelity Advisor Freedom 2065 Fund (FDFZX): 1%

Let’s say you invested $6,000 a year for the next 30 years. Assuming a 6% average rate of return, your final account balance, after fees, would be approximately:

  • $418,600 with a 1% expense ratio
  • $462,000 with a 0.46% expense ratio
  • $495,000 with a 0.08% expense ratio

In this example, you could potentially lose out on $76,400 in retirement savings if you choose a target-date fund with a 1% expense ratio instead of 0.08%, assuming all other factors are equal.

Target-Date Funds vs. Index Funds

Target-Date Fund Index Fund
A group of mutual funds that automatically rebalance themselves based on your anticipated retirement date A mutual fund or exchange-traded fund that tracks a specific index, such as the S&P 500 or Russell 2000
Automatically rebalances over time Doesn’t rebalance
Actively managed by professionals; may have higher fees Passively managed; may have lower fees
Best for those who want a hands-off approach to saving for retirement Best for those who want their investment returns to match the performance of a specific index

Target-date funds and index funds are both ways to invest in the stock market. However, there are some differences between the two.

Target-date funds are almost always used as a way to save for retirement. Simply choose a fund that correlates with your anticipated retirement year and you’re done. The fund automatically shifts and changes as your retirement date approaches.

An index fund tracks a specific stock-market index, such as the S&P 500. It can be used for almost any goal—retirement savings, long-term investing, you name it. Although index funds are diversified, you often need to invest in several different funds to get an asset mix that matches your risk tolerance and goals. You’ll also need to rebalance it yourself.

Last, target-date funds are typically more expensive than index funds. That’s because target-date funds are actively managed, meaning there's a team of people making decisions about where to invest the money. Index funds are passively managed, so there's not as much of a need for a team of people.

Not all target-date funds have high fees, and not all index funds have low ones. Always research specific funds to estimate how much you may pay to invest in them.

Pros and Cons of Target-Date Funds

Pros
  • Automatically rebalance based on the investor's retirement date

  • Can offer a more hands-off approach to investing

Cons
  • Fees can be higher than other investment options

  • Asset allocations may not be ideal for everyone

Pros Explained

  • Automatically rebalance based on the investor's retirement date: Target-date funds automatically shift to become more conservative as you get closer to retirement. This means you don't have to worry about changing the assets in your portfolio over time. It’s all done for you.
  • Can offer a more hands-off approach to investing: The main advantage of target-date funds is their simplicity: They allow investors to "set it and forget it.” This can take the guesswork out of trying to invest for retirement.

Cons Explained

  • Fees can be higher than other investment options: Target-date funds are actively managed by professionals and may have higher fees that can eat into your investment returns.
  • Asset allocations may not be ideal for everyone: Because they are designed to be "one size fits all," target-date funds may not be the best options for investors with specific goals or risk tolerances.

What Target-Date Funds Mean for Individual Investors

Target-date funds can be great fits for people who don't have the time or knowledge to build their own investment portfolio for retirement. However, target-date funds have a few drawbacks, including potentially high fees and a one-size-fits-all approach that may not align with your needs.

If you’re on the fence about whether a target-date fund is right for you, consult a financial planner who can help you weigh your options.

Key Takeaways

  • A target-date fund is a type of investment that automatically adjusts its asset allocation over time to become more conservative as the target date (usually retirement) approaches.
  • Target-date funds offer a simple way for investors to save for retirement without having to worry about picking the right funds.
  • Some employers use a target-date fund as the default investment option inside your 401(k) or employer-sponsored retirement plan.
  • Target-date funds have a few drawbacks, including high fees and a “one size fits all” approach that may not match your goals and risk tolerance.

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