What is a Target-Date Fund?
Target-date funds are designed to optimize returns for investors by a specific date. Typically, the funds concentrate on riskier growth companies to generate returns in the early years. As the target date draws nearer, they try to hold onto those gains by shifting their weight towards safer, more conservative options.
Target-date mutual funds are well-liked among investors who are putting money away for retirement. Still, they are also useful for people who are trying to cover a sizable future expense, like a child’s college tuition.
How to Operate a Target-Date Fund
Target date funds aim to achieve the investment return goal using a typical portfolio management approach to target asset allocation across the fund’s period. Target-date funds acquire their name from the year the investor intends to use the assets, and they are regarded as very long-term investments. Vanguard, for instance, introduced its Target Retirement 2065 products in July 2017. The funds have a 48-year time horizon due to their intended use date of 2065.
The portfolio managers of a fund use the established time horizon to formulate their investment strategy, which is often grounded in conventional asset allocation models. The target date is another tool the fund managers use to gauge how much risk the fund is prepared to take. Managers of target-date portfolios usually review the risk levels of their portfolios once a year.
Particular Points to Remember
After its initial launch, a target-date fund is more strongly weighted toward speculative but high-performing assets due to its high tolerance for risk. Portfolio managers will reallocate the allocation of investment categories during the yearly adjustment.
As a target-date fund gets closer to its target date, its asset mix and level of risk also grow more conservative. Local and foreign shares are often included in higher-risk portfolio investments. Low-risk assets in a target-date portfolio typically include fixed-income instruments like bonds and cash equivalents.
The allocation glide path, or asset movement, is often shown over the investment time horizon in fund marketing materials. The funds structure the glide rate to get the most cautious allocation at the designated goal date.
Beyond the target date, some target-date funds, often referred to as “to funds, will manage assets to a predetermined asset allocation. Allocations are more strongly weighted toward low-risk, fixed-income assets in the years after the goal date. Beyond the target date, some target-date funds, commonly called “through” funds, will manage assets to a predetermined asset allocation. This is in contrast to other “to funds” or target-date funds, which will no longer change the allocation of assets upon reaching the target date.
Target-date funds are only available as mutual funds these days. As of right now, there are no listed analogous ETFs.
Benefits and Drawbacks of Target-Date Investments
Target-date funds are a favorite among investors in 401(k) plans. Investors choose a single target-date fund to align with their time horizon rather than selecting many assets to build a portfolio that will assist them in reaching their retirement objectives. For instance, a younger employee who wants to retire in 2065 would choose a target-date 2065 fund, but an older employee who wants to retire in 2025 would select a target-date 2025 fund.
These funds lessen the requirement for additional assets. According to some financial experts, if you invest in one, it ought to be your sole investment in the plan. The reason for this one-and-done strategy is that making more investments might distort the allocation of your whole portfolio. But after you’ve chosen a fund, this is the best kind of investment that you can set and forget.
Negative aspects
Naturally, there are drawbacks to target-date funds’ autopilot feature. The preset rearranging of the portfolio’s components may not be appropriate for a person whose requirements and objectives change over time. Humans are dynamic beings with ever-changing wants.
What happens if you have to retire significantly before the intended date or decide you’d rather work longer? Furthermore, there is no assurance that the fund’s returns will increase in line with inflation. There is no assurance that the fund will provide any income or profits. An investment, not an annuity, is what a target-date fund is. These funds are vulnerable to loss and underperformance, like any other investment.
Additionally, target-date funds might be costly in terms of investing. Since they are technically a fund of funds (FoF), which is a fund that invests in other mutual funds or exchange-traded funds, you will be responsible for paying both the target-date fund’s fees and the expense ratios of the underlying assets.
Naturally, there are more and more no-load funds, and generally, charge rates have been falling. However, it’s something to be aware of, mainly if many of your fund’s investments are in passively managed vehicles. Why spend double the fees if you could purchase and keep index funds independently?
It’s also important to remember that target-date funds with similar names are not the same, or their assets differ. Yes, all 2045 target-date funds will include a significant equity component, although some may choose to focus on local equities while others may consider foreign equities. While some may choose high-yield, lower-grade debt instruments, others may select investment-grade bonds. Verify if the fund’s portfolio assets match your risk tolerance and comfort level.
Pros
- The best approach to investing in autopilot
- One-stop shop—no need for additional assets
- A diverse portfolio
Cons
- more significant costs compared to other types of passive investing
- Income is still being determined.
- Potentially inadequate inflation hedging
- Limited flexibility to adjust investor demands and aims
Target-Date Fund Example
One investment manager that provides a wide range of target-date funds is Vanguard. The Vanguard 2065 fund (VLXVX) and the Vanguard 2025 fund (VTTVX) are contrasted in the following table.
The cost ratio for the Vanguard Target Retirement 2065 Fund (VLXVX) is 0.15%. 90.5% of the portfolio was allocated to equities as of Q2 2022, and the remaining 9.5% to bonds. It uses additional Vanguard mutual funds to fulfill its objectives. Vanguard Total Stock Market Index held 53.8% of its investments, followed by Vanguard Total International Stock Index Fund (36.6%), Vanguard Total Bond Market II Index Fund (6.7%), and Vanguard Total International Bond Index Fund (2.9%).
The cost ratio for the Vanguard Target Retirement 2025 Fund (VTTVX) is 0.08%. It is more cautious as it matures 20 years before the 2065 fund. Its portfolio is weighted 42.5% in bonds and 57.5% in equities as of Q2 2022. Vanguard Total Stock Market Index Fund received 34.7% of its assets; Vanguard Total Bond Market II Index Fund received 27.6%; Vanguard Total International Stock Index Fund received 22.7%; Vanguard Total International Bond Index Fund received 12.2%; and Vanguard Short-Term Inflation-Protected Securities Index Fund received 2.80%.
Both funds invest in the same assets. The 2065 Fund, on the other hand, has a comparatively lower proportion of bonds and cash equivalents and is more strongly weighted toward equities. The 2025 Fund is less volatile and more likely to hold the assets the client needs to withdraw in 2025 since it has a higher weighting in fixed income and fewer equities.
Both Vanguard target-date funds will maintain an asset allocation mix of around 20% U.S. equities, 10% foreign stocks, 40% U.S. bonds, 10% foreign bonds, and roughly 20% short-term TIPS in the years after the target date.
After the Target Date, Can I Keep My Target-Date Fund?
Indeed. But, depending on the kind of target-date fund you have, it may act differently. A “to-fund” will keep its final asset allocation as of its maturity date forever, whereas a “through fund” will gradually shift its allocation toward more conservative assets.
Do Target-Date Funds Cost a Lot?
Target-date funds often have higher cost ratios than a typical mutual fund. This is because a target-date fund—even one that tracks an index—is just a fund-of-fund that invests in other mutual funds. In addition, the fund is more active than a typical index fund since it must constantly adjust its holdings to follow the glide path. Nonetheless, many target-date index funds on the market now offer minimal cost ratios of 0.10% or less.
Can a Target-Date Fund be utilized in an Individual Retirement Account or 401(k)?
Indeed. Today, the majority of plan providers allow target-date fund access. But for them to function correctly, you must be cautious to allocate almost all your money to target-date funds alone. This is due to the possibility that investing in other assets might negate the benefit of the glide path offered by the target-date fund.
Should I Choose a Different Target-Date Fund if I Want to Retire in a Year Other Than a -5 or -0?
Most target-date funds are set to mature every five years, for example, in 2030, 2035, 2040, 2045, and so on. If you want to retire in 2033, there is no hard and fast rule. You may select the closer-term 2030 fund if you have a lower risk tolerance, or you can round up to the 2035 fund. Additionally, you can allocate 40% of your funds to the 2030 fund and 60% to the 2035 fund.
Conclusion
- A kind of mutual fund or exchange-traded fund known as a target-date fund rebalances asset class weights regularly to balance risk and return over a specific period.
- A target-date fund’s asset allocation is usually intended to progressively move toward a more conservative profile as the target date draws near to reduce risk.
- Target-date funds are popular because they allow investors to automate their investments into a single vehicle.
- Target-date funds typically mature in 5-year increments, such as 2035, 2040, and 2045.
- Target-date funds are still more costly than other mutual fund categories, although their expense ratios have decreased dramatically in recent years.
