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Investing can be a complicated process. The thought of having to decide where to put your money, keeping track of the news, and looking out for better opportunities is overwhelming. What if you wanted a place to put money to let it grow for your retirement?
For those reasons, target-date funds might be the right option for you. However, every upside has its downsides.
Before you decide to go ahead with it, read on about how target-date funds work, what their pros and cons are, and how you might make the best use of it.
What Is a Target-Date Fund?
These funds are designed to meet an investor’s capital needs in the future or on a “target date.” They are mostly employed for retirement planning but can also be used for large future expenses, such as college tuition.
How Do Target-Date Funds Work?
Asset allocation, the technique of balancing risk and return by dividing assets among investment vehicles, is one of the key features of successful investing. The way we allocate our assets largely depends on investment goals and age.
Rebalancing a portfolio means adjusting the weighting of assets in a portfolio. In general, younger investors can own more speculative assets, such as stocks, because they have time on their side.
However, as they grow older, the amount of money in speculative assets should progressively shift towards conservative assets, such as bonds.
This is because as we age, we usually place more emphasis on preserving our wealth than risk losing money investing in assets with potentially high returns.
The process of rebalancing a portfolio every few years can be tedious for most people as it requires research, deep thought, and complex calculations.
Target-date funds feature the process of rebalancing. All target-date funds have a team of analysts working for them to ensure that rebalancing is done efficiently and properly. In addition, every target-date fund contains a glide path in its marketing material, that is, the shift of assets across the entire investment time horizon. Therefore, it provides a way to “set and forget” about investing.
There are two ends to the glide path depending on the fund. A “To” fund adjusts your allocation until the specified date.
On the other hand, a “Through” fund allows modifications to the asset allocation beyond the target date.
There is no clear difference on which fund is better, but it’s something that you should take note of to understand better what the fund plans to do with your invested money.
Target-Date funds generally reduce risk as it approaches their target date. The investor’s ability to take risk is lower as they get close to retirement. This prevents the investor from losing a big chunk of their funds in the years leading up to their retirement as they will not have time to make it back.
How to Invest in Target-Date Funds
Target-date funds are usually a pre-set choice for when investing in a 401(k). So, if you did not make any adjustment to your 401(k), chances are you are already investing with a target-date fund.
In fact, more than 50% of 401(k) investors have all of their 401(k) assets in target-date funds as of 2020.
Another way is to open a brokerage account to shop for a target-date fund. This can be done online or through a fund manager.
>> More: How to Start Investing
Advantages of Target-Date Funds
- Autopilot Your Investment Strategy: Since target-date funds already have a built-in mechanism that adjusts asset allocation with age, there is no need to be concerned with the technicalities of investing.
- Easily Adjust Position: Target-date funds usually provide options to further customize a portfolio according to your needs. For example, it may offer options like adjusting risk tolerance or extending the target-date end. Note that the interval between end dates is usually 5 years.
- Diversified Portfolio: Each mutual fund or ETF contains a basket of securities of a particular or mix of asset classes in itself. A target-date fund invests in few mutual funds and/or ETFs since it is a “fund of funds.” Therefore, by investing in a target-date fund, you will achieve a well-diversified portfolio.
- Wildly Simple and Easy to Do: The best way to start is to open a 401(k) or IRA. Since professionals will manage your investments, there’s not much else to think about.
Disadvantages of Target-Date Funds
- Higher Expense Ratios: Target-date funds are “funds of funds.” This means that they are mutual funds that invest in other mutual funds or ETFs. Because every fund has an expense ratio or the percentage of fees associated with the invested amount. A target-date fund contains two layers of expenses: the target-date fund itself and each of the funds that the target-date fund invests in. Those fees are combined into one and are usually stated up front in the product. The average target-date fund has an expense ratio of 0.5%, which means a $10,000 investment will cost you $50 per year. While it seems like a small percentage, a portfolio worth $10,000 invested over 20 years with a 0.50% expense ratio will lose $6,000 to fees assuming that the investment will grow and compound over a 20-year period.
- Lack of Control: Target-date funds do not provide flexibility with investing strategies. By investing with a target-date fund, you agree to how it manages your investments. This is detailed in the product prospectus. The strategies may not be personalized to your risk tolerance and desire for returns. In that sense, you are forced to ride along with their investment strategy.
- Can Still Lose Value: Any form of investment carries the risk of underperforming the market or losing money, no matter how well a portfolio is rebalanced across an investor’s lifespan.
What Is an Example of a Target-Date Fund?
One example of a target-date fund is LifePath® by Blackrock. The product description page states its purpose and provides two investing strategies that you can go with: a passive or more active approach.
A passive approach means that the target-date fund invests heavily in ETFs or index funds. Hence it is associated with a lower cost.
An active approach, as described on the product page as “ a deliberate process to seek outperformance and additional return,” suggests that it will incorporate both mutual funds and ETFs. More active management comes with higher management fees but also potentially higher returns.
Can You Take Money Out of a Target Date Fund?
You can take money out of the target-date fund at any time. However, some funds may have a holding period before you can make any withdrawals from them.
If the target-date fund was purchased through a brokerage, selling out of it may incur heavy taxes on capital gains.
However, if you can afford to pay the taxes, it might be wise to make the transition to owning it in a tax-advantaged retirement account such as an IRA of 401(k).
Of course, this is best done in the earlier stages of owning one through a brokerage when the damage is still relatively small.
>> More: What Is a Roth IRA?
Mutual Funds vs. Target-Date Funds
Mutual funds are professionally managed funds that pool money from many investors to purchase securities.
Their strategies vary according to the fund manager responsible for managing the mutual fund, who usually seeks higher than average returns for their investors.
They may contain one or a variety of asset classes, and they usually focus their investments on particular sectors or regions of the world.
Target-date funds may invest in a variety of mutual funds. Depending on the goals of the mutual funds and their dominant asset class, target-date fund managers will decide, on your behalf, what it thinks is the best option according to its glide path.
Target-Date Funds vs. Exchange-Traded Funds (ETFs)
ETFs allow investors to invest passively in a low fee, highly diversified basket of securities.
Instead of purchasing a particular stock or bond, investing with an ETF allows investing in an entire sector or asset class.
The decision to purchase an ETF lies on the investor and their goals. A target-date fund takes out the process of deciding which ETF to invest in according to its glide path.
Are Target-Date Funds a Good Investment?
Target-date funds provide one of the easiest ways to start investing. However, its benefits lie within its use rather than performance because no matter how promised the returns are for the future, there will always be a risk of underperformance.
Another consideration might be the fees associated with target-date funds. If you are not willing to lose as much money in fees as illustrated above, then a target-date fund might not be a good investment for you.
Who Should Invest in Target-Date Funds?
Those who do not intend to keep up with news about their investments and want a hassle-free approach to investing might consider investing in target-date funds. Individuals who have grasped the importance of time and investing for retirement but have no interest in learning how to invest could benefit most from target-date funds.
All they have to do is to contribute consistently to their 401(k), choose a target-date fund, and decide when they want to retire.
Are Target-Date Funds Safe to Invest in?
The risks with target-date funds are the same with any form of investment — underperformance and losing money. However, some argue that this is the better way to invest because by doing so, you are leaving it to the experts to handle investment decisions. Moreover, target-date funds adjust its balance each year to reduce risk as it approaches the target date.
Bottom Line: What Is a Target-Date Fund?
Target-date funds provide an easy way to get into and stay invested for a long period of time. It contains a mechanism that adjusts your portfolio allocation as you age, which is the standard for successful investing.
The best way to use this is with a tax-advantaged retirement saving account like a 401(k) and IRA. However, you are likely to pay higher fees than investing in a self-created portfolio of index funds.
In addition, the caveat to owning a self-created portfolio is having to manage it on your own. Therefore, target-date funds are best for those seeking convenience and ease with investing rather than achieving higher returns and lower fees.