Because they’re intuitive and easy to use, target-date funds are an increasingly popular way for individuals to invest in their future – namely, retirement. In fact, more than $2.8 trillion were invested in them at the end of 2022, according to Morningstar.
Target-date funds are especially popular in 401(k) plans, as they are a logical default option offered by 80% of all plan sponsors. Yet, MFS’ 2023 Retirement Outlook survey found gaps between workers’ understanding of how target-date funds actually function. These misunderstandings can have dire implications for saving, investing and living in retirement.
So, let’s dive into target-date funds and uncover some of the pros and cons of investing in them.
What is a Target-Date Fund?
A target-date fund – also known as a lifecycle fund, dynamic-risk fund, or age-based fund – is a type of investment fund structured to maximize an investor’s returns by a specific date.
These funds are designed to simplify the process of investing for retirement by providing a diversified portfolio that automatically adjusts its asset allocation over time based on the investor’s target retirement date.
To invest in a target-date fund, you begin by answering the question: When do you plan to retire? Your answer will be your “target date” year.
For example, a 22 year-old nurse today planning to retire at age 66 might invest in a 2065 target-date fund. The year in the name of the fund is the approximate date that an investor would plan to start withdrawing money.
Over time, as the nurse moves closer to the target date (2065), a portfolio manager will rebalance the fund and adjust the investments it owns so that it becomes more conservative.
The principal value is not guaranteed at any time, including at the target date. Because of this, it’s important to know how your target-date fund is managed and that you monitor your investment.
The Pros of Target-Date Funds
Target-date funds offer several advantages that make them a popular choice for many investors, especially those who prefer a simplified and hands-off approach. Here are five of the key advantages to target-date funds:
- Diversification: Target-date funds provide instant diversification by investing in a mix of asset classes, such as stocks, bonds, and sometimes other investment types. This diversification helps spread risk across different types of assets, reducing the impact of poor performance in any single investment.
- Automatic Rebalancing: The fund’s asset allocation is automatically adjusted over time according to a predefined glide path. This ensures that the fund remains aligned with the investment horizon. Rebalancing helps maintain the desired mix of assets and prevents one asset class from dominating the portfolio.
- Gradual Risk Reduction: As the target retirement date approaches, the fund’s asset allocation becomes more conservative, with a greater emphasis on lower-risk investments like bonds. This gradual reduction in risk helps protect investors’ portfolios from the potential impact of market downturns as they near retirement.
- Low Maintenance: Investors don’t need to actively monitor and adjust their investments as market conditions change. The fund manager handles the ongoing management and rebalancing, reducing the need for frequent attention.
- Accessibility: Target-date funds are commonly offered through retirement plans, such as 401(k)s, making them easily accessible to many investors through their workplace.
The Cons of Target-Date Funds
But before you invest in a target-date fund, let’s weigh these cons against the benefits to determine whether they align with your specific circumstances and preferences. Here are five of the key disadvantages to target-date funds:
- Limited Customization: Target-date funds are designed to be a one-size-fits-all solution, which means they may not align with your unique financial goals or risk tolerance. Investors seeking more control over their portfolio allocation may find target-date funds to be too rigid.
- Cost Considerations: While target-date funds often have reasonable expense ratios, these fees can still add up over time and ultimately have an impact on your overall returns. It’s important to carefully review the fund’s fees before you commit to investing in a target-date fund.
- Lack of Active Management: Target-date funds follow a predetermined asset allocation strategy that gradually becomes more conservative as you approach your target retirement date. Therefore, this passive approach does not take advantage of market opportunities or adapt to changing economic conditions like actively managed portfolios do.
- Limited Investment Options: Investors who prefer to handpick individual stocks or bonds might find target-date funds limiting in terms of investment choices. These funds often restrict your options to a preselected mix of assets, limiting your ability to make tactical investment decisions.
- Risk Tolerance Mismatch: Target-date funds assume that investors with the same retirement date share similar risk tolerances. However, individuals have diverse financial situations and risk appetites, so relying solely on a fund’s predetermined allocation may not accurately reflect your comfort level with market volatility.
In conclusion, target-date funds offer a simplified and hands-off approach to retirement investing, making them an attractive option for investors. Their automatic rebalancing and gradual risk reduction can ease the burden of managing a portfolio over time. However, there are some notable drawbacks to consider. These include limited customization, potentially higher costs, and the absence of active management.
The decision to invest in target-date funds ultimately comes down to your financial goals, risk tolerance, and investment preferences. It’s essential to carefully evaluate both the advantages and disadvantages to determine if target-date funds are the right fit for your retirement plan.
If you need assistance in the decision, our advisors are here to help. You’re welcome to schedule a complimentary consultation with our team using the link below.