Target date funds (TDFs) are one of the most popular investment instruments for saving for retirement. 401(k) plans in the U.S., which you might have heard of, also invest their capital by default in target date funds.
In this article, we’re going to get to know more about these funds, what they do, how they work, and whether they are good investments to make.
Understanding target date funds
TDF managers mix capital into a mix of stocks, bonds, and other investments and package it all under one head to help to help saving for retirement easier. The thing that makes TDFs different from other funds is that they take on more risk in the beginning, when you’re young, and become more conservative as time goes on and you near retirement.
By investing in TDFs, investors aim to take some of the uncertainty out of retirement investing and leave the return generation to a professional.
How do they work?
The main consideration for a TDF manager is your time horizon. Based on how much time and money you have to save for retirement, TDFs can allocate your funds to specific instruments to balance risk and longevity.
These allocations usually encompass all major investment vehicles including equities, fixed income securities, and sometimes alternative investments.
TDFs implement a glide path strategy:
- The asset allocation in this strategy shifts gradually from a higher exposure to equities in the early years to a higher allocation towards fixed income and cash equivalents as the target retirement date approaches.
- This is done to ensure that returns are maximised when the fund still has many years to go, but capital is conserved when retirees might need to withdraw their capital in cash.
Since these funds are managed by professional investment managers, they are largely tuned to handle adverse market conditions, ups and downs of economic trends, and differences in investor demographics.
Consequently, TDFs are considered to be extremely long-term investments. For instance, Vanguard’s Target Retirement 2065 products launched in 2017 were aimed at an investment horizon of 48 years.
Types of target date funds
- Active funds come with a dynamic portfolio management team that selects actively managed investments with an objective to outperform broad markets. These funds usually come with a higher management fee, and hence lower returns.
- Passive funds will select passively managed instruments that are designed to track its performance with an index like the S&P 500 or the NASDAQ.
- Hybrid funds are a combination of both these options where some investments are actively managed and the others track the broad market.
Benefits and considerations
Like with any other financial product, target date funds also have their own benefits and disadvantages. Here they are, briefly:
Advantages
One of the biggest and most obvious advantages of a target date fund is that you leave the stress of investing your savings for retirement to an investment professional who, in all probability, knows more about investing than you do.
Another concern that is bypassed by investing in a TDF is longevity risk, which is the risk that your money could lose its value over time. Investing in funds like these makes sure that your money, at the least, is keeping up with inflation. Many of these funds invest in equities right up to the target date, which means there is a very high likelihood that you will eventually see a lot of appreciation in capital.
By holding a wide range of investments that are not correlated with one another, TDFs also reduce market risk as much as possible. When one investment fails, another may rise – or simply not fall as much. This could help you weather recessions and market crashes better than others.
Disadvantages
TDFs are a great choice for investors who have a well-defined savings goal and target retirement date, but don’t have the time or skill to construct a portfolio by themselves.
However, if you’re someone who has more ambitious plans – like retiring before 55 or after 75 – you might need some more personalisation in your investments. This could also come with more rebalancing and re-evaluations, which a TDF might not do.
Fees are also another consideration in a TDF. Because most of these funds are actively managed, they come with a lot of fees – which you could avoid altogether if you just invested in an ETF or passive index fund.
Frequently Asked Questions
Target date funds automatically adjust asset allocation based on the investor’s retirement timeline, while traditional mutual funds may require manual rebalancing.
Taxes on target date funds depend on factors such as dividends, capital gains, and your personal investment horizon. We encourage you to consult with a tax advisor to understand your specific tax implications.
Yes, you can diversify your portfolio by investing in multiple target date funds with different target dates. However, some of them do have lock-in periods so make sure you have an emergency fund for cash in case you need it.
Asset allocations are typically adjusted periodically based on the fund’s glide path. This adjustment frequency varies among funds and may occur annually or more frequently closer to the target date.
Post the target date, the fund maintains a conservative allocation. You can choose to stay invested or redeem/rollover based on your needs.