Have you heard of analysis paralysis? It’s when you spend so much effort thinking about every facet of a situation that you become bogged down and end up never making a decision. While analysis paralysis can affect a lot of aspects of life, here I care about how it affects your money. And one of the key ways analysis paralysis can affect your money is if you get so caught up in deciding what to invest in that you end up putting off investing too long. Luckily (maybe), there’s a type of investment vehicle that can take a lot of decision making out of the process. It’s called a target date fund.
What Is A Target Date Fund?
Target date funds are a type of mutual fund that automatically rebalance your investment portfolio’s mix of stocks, bonds, and cash equivalents.
Every target date fund has – get this – a date associated with it. So clever, those namers. Well, okay, really it’s a year, not a specific date. That year is meant to be the approximate time when the investor plans to retire. So if you are currently 25 years old and you plan to retire around age 65, you would pick a 2057 target date fund. In actuality you would probably pick a 2055 or 2060 fund, since they tend to be designed in five or ten year chunks. And if you are currently 50 and want to retire at age 60, you’d be looking at a 2025 or 2030 target date fund.
You might also hear target date funds referred to as lifecycle funds or age-based funds. That’s because they are designed to get a more conservative asset mix over time – as a person ages.
Target date funds are often found in 401(k), TSP, and other similar retirement plans. You can also find them for college savings accounts, since the expected timeline there is usually easy to predict.
How does a Target Date Fund work?
With a typical mutual fund, there is an objective that basically stays steady over time. For instance, the objective might be to have lots of short term growth, or to have very stable returns. The holdings within the mutual fund will change, but the objective is pretty set in stone.
With a target date fund, the objective is to achieve a good asset allocation for different stages of life. For instance, a target date fund where the target date is 40 years in the future will have a different allocation than one with a date 5 years in the future. That’s because, generally speaking, people want their money more conservatively invested as they get closer to retirement (or whatever other reason you are planning to use the money). The closer you get to needing the money, the less risk you generally want to take on.
The further out the target date fund’s date is, the more aggressive the stock allocation and the less bonds and cash equivalents it would have. Then, as the investor gets older, the fund managers will rebalance the asset allocation to make it less volatile – meaning, more bonds and cash, less exposure to stocks.
Investors like target date funds because they are very hands-off. Pick your fund and set up automatic deposits, and the rest of the work is basically done for you. Easy peasy.
What’s so easy about Target Date Funds?
Target date funds are managed using what’s known as a glide path. The fund managers decide how the fund’s asset allocation will change over time, accounting for stocks, bonds, cash, etc. Then the managers simply follow this glide path for the life of the fund.
In theory, once you start contributing to a target date fund your work is done….at least until it’s time to start withdrawing money. You don’t have to worry about rebalancing your account as you get older and theoretically need a lower risk investment mix. All of the rebalancing is performed by the fund manager, meaning zero effort on your part.
Of course, I’ll always recommend that you check it occasionally (I like once per year) to make sure the fund is still meeting your needs. But if the answer is yes, you can’t get much easier than a target date fund.
All Of That Sounds Great. What’s The Catch?
This does sound nice, right? Well, there’s a big problem with this approach.
Target date funds lump everybody together based on an expected retirement date. But people aren’t all the same.
A big – probably the biggest – concern with target date funds is that it doesn’t account for the investor’s risk tolerance. Just because two people plan to retire at about the same time doesn’t mean they have the same risk tolerance. Some risk-averse people are willing to up their savings rate to account for their lower risk tolerance. Some risk-friendly folks might find target date funds too conservative.
Target date funds also don’t account for an investor’s goals as well as another fund might. Since they get more conservative over time, it might not have enough growth. Or it might be too unstable towards the beginning.
And, target date funds have higher fees than I personally like to see. According to this August 2016 Market Watch article, the average expense ratio for a target date fund is 0.73%. Plenty exceed 1%. Meanwhile, in my own personal fund choices I aim to never exceed 0.2%, and I’m usually far under that.
Do Target Date Funds work for early retirees?
They can, if you pick the fund based on asset allocation and glide path, not date.
You see, an early retiree usually needs their investments to be higher risk/higher potential reward to account for the much shorter investment timeline. The opposite train of thought is that early retirees don’t have time to recover from mistakes, so they might have a much lower risk tolerance than other people their age. From what I’ve seen, the former seems more common than the latter, but in both cases the person is thinking through their risk allocation with their objectives and timelines in mind.
If you want to retire early, your risk tolerance is high, and you are interested in target date funds, you should consider choosing one that has the date furthest into the future – not based on when you actually plan to retire. Alternatively, if you want to use a target date fund but your risk tolerance is very low, you can choose one with an earlier date than your planned retirement.
Post-retirement, you can always move your portfolio into a different target date fund to ensure it keeps rebalancing in a way that’s more aligned with your needs and desires at that stage of your life.
Should You Use Target Date Funds?
C’mon. You already know what my answer is gonna be.
It depends.
If you want to be a lazy investor (100% not an insult, at least 50% a compliment) then target date funds might be right for you. They really are epically easy.
But if you are going to use them, please make sure you are doing your homework! Check out the fund’s prospectus. Find out its asset allocation and planned glide path and decide whether it works for you. If not, look at other target date funds.
And don’t think, for instance, that if a 2040 fund from one company doesn’t fit your preferences, that means all target date funds won’t fit your preferences. No two funds are exactly alike. Compare several funds from several different companies with different target dates to see which one fits your needs.
Anything Else To Know?
Yes!
Target date funds have two general types – “to” funds and “through” funds. A “to” fund will rebalance the asset allocation until the target date is met….but then it stops. It achieves its most conservative asset allocation at the target date, then stays that way in perpetuity (theoretically). A “through” fund keeps rebalancing after the target date, so as you get older it will continue to get more conservative. Make sure you are choosing the type that works for your goals.
Gentle reminder: I am not a personal finance professional. You should always do your own research before making changes to your finances and talk to a professional if you need additional help. Please read my full disclaimer here.
Do you utilize target date funds? Why or why not?
I have the vast majority of my TSP in the Lifecycle 2040 Fund. I picked this early on when I didn’t know what asset allocation was. Later, I realized that it was just easier and I’ve done ok. As I’ve learned more, I’ve been thinking more about locking in gains with strategic asset relocations. It seems like the less you know, the better you are, as long as you’re consistently investing in mostly equities.
There is some strong evidence that being a lazy, unknowledgeable investor is one of the best types to be!