How Target Date Funds Work

Target date funds are funds that has an asset allocation mix that is constantly changing – becoming more conservative as the target date (usually aimed to coincide with a retirement date) gets closer. The farther off the fund is from retirement, the more higher risk assets are held. The logic is that with a longer time frame available the fund will be able to ride out any market downturns that may happen in the future.

With a shorter time farm (closer to retirement) the fund switches to more fixed-income investments (lower risk). They get rebalanced automatically over time so that the investor isn’t required to rebalance periodically.

Image Credit: Ken Teegardin (Flickr)

Image Credit: Ken Teegardin (Flickr)

Target date funds are gaining in popularity. In 2013 there were over $500 billion invested in target date funds within the U.S. alone. They’re forecast to make up over half of all defined contribution funds ($3.85 trillion) by 2020.

At my workplace the investment provider has now started offering a handful of target date funds – catering to employees who don’t want the time and effort that comes with handling your investments. Up until last year they only offered mutual funds.

Lower Fees are Best

Target date funds are ideal for anyone looking for simplicity. If you aren’t interested in being “hands on” with your investments, target date funds might be suited for you.

Like any other fund, fees matter – as higher fees will erode overall investment returns. In general the higher the fees, the lower the returns. Future Advisor found that investors who paid the lowest fees per $10,000 invested ($39) had a return of 7.2% while those who paid $160 or more (per $10,000 invested) had a return of 2.8%.

Target date funds should (in theory) have lower fees as the investment mix changes over time from equities to fixed income instruments.

One Size Fits All

One main issue with target date funds is that they’re billed as a “one size fits all” investing solution – when in reality everyones needs are different.

Two investors may have the same investment objectives but completely different tolerance for risk, need for growth or investment profile. A target date fund doesn’t take this into account, and it might not be the right fit for those looking for a customized investment solution.

A target date fund basically attempts to smooth out the investment timeline by slowing switching from equities to fixed-income investments. This idea works well if your life happens in a smooth line, but everyone has bumps along the way which can dramatically alter an investment portfolio.

Let’s say you plan to retire in 2045 with a wife and two grown children. the smoothness of a target date may seem appealing now, but what happens if one child falls ill 5 years before the planned retirement and you need more income than you planned? Switching to almost entirely fixed income would mean you’d deplete your investments much faster than planned, so switching to them from equities may not make sense in this case.

Conclusion: target date funds are best suited to those who have no interest in handling the day to day work involved with investing. On the other hand, every investor’s needs and tolerance for risk is different and a target date fund doesn’t necessarily suit everyone.

Would you buy a target date fund? Why/why not?

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