Target-Date Funds: Are They Right For You?

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(Image provided by Bedel Financial Inc.) (Image provided by Bedel Financial Inc.)

No matter what your investment skill level, chances are you've come across something called a "target-date fund" - sometimes referred to as a "lifecycle" or "age-based" fund. The most common place you'll find this particular type of investment is in your company's 401(k) retirement plan. So how does it differ from other funds? And should you invest in one?

Target-date funds have become increasingly more prevalent in recent years. According to investment research company, Morningstar, at the end of 2017 more than $1.1 trillion was invested in these types of funds. That’s up from the $158 billion reported at the end of 2008! These types of investments have their pros and cons, so be sure to get familiar with them to ensure they fit in with your overall investment plan.

What is a Target-Date Fund?

First introduced in the 1990s, target-date funds are usually offered by investment companies as mutual funds. A target-date fund is composed primarily of a combination of pre-selected stock and bond mutual funds. Similar to most other mutual funds, its goal is to grow assets over time.

But here's the difference: Each target-date fund is associated with a date that corresponds to when the owner will use the funds. Most people select a fund with a target date that reflects their anticipated retirement year. The fund, then, is designed to become more conservative and take on less risk the closer it gets to the "target date."

Here's an example. Target Retirement 2065 Fund has almost fifty years before it reaches its target date of 2065. So, its funds will be invested much more aggressively today and become more conservative over time. Today, its portfolio may look something like 90 percent stocks and 10 percent bonds. On the other hand, if we look at a Target Retirement 2025 Fund today, that portfolio should be much more conservative since its target date is less than ten years away. It may have a portfolio that looks something like 60 percent stocks and 40 percent bonds (although, as we will see, this can vary).

The Positives of Target-Date Funds

Here are some reasons you might find target-date funds an attractive addition to your portfolio:

  • Simple. Target-date funds can be helpful for investors who may not be as financially sophisticated or who want to take a hands-off approach to their portfolio.  Because of the way a target-date fund is designed, it allows people to take a “set-it-and-forget-it” approach. The fund manager(s) changes the allocation systematically and rebalances as necessary over time without the investor having to worry about it.
  • Diversified. Target-date funds are diversified to reflect their time horizon among stock (domestic and international) and bonds as well as industry representation. This relieves the investor of making any allocation decisions.

There’s Always a Downside

While target-date funds are convenient and require little, if any, management on your part, don’t sign up yet! You also need to consider their limitations:

  • Lack Customization Capabilities. Perhaps the biggest downside is the lack of customization. When you invest in a target-date fund, you are giving the fund manager(s) full discretion over your funds. Your money will be invested without taking your own personal financial situation into account. Not everyone has the same long-term goals and not every investor retiring in the same year will have the same tolerance for taking risk. Furthermore, these funds don’t take into account changes that may occur throughout your life that may change your risk tolerance such as an income change, early or late retirement, or loss of a spouse.
  • Fees Can Be Substantial. Usually the fees on target-date funds are higher than other types of mutual funds offered in a retirement plan. This is because they pass on the fees from the underlying investments that make up the fund, along with adding their own management fee. Morningstar reports that the average target-date fund’s annual fee is more than 1 percent.
  • Target-date Funds Can Differ. Not all target date funds follow the same model. Some are “through” and some are “to,” meaning some invest through the target date and continue to become increasingly more conservative years after the fund’s target date. Others invest to the target date and then stop taking risk within the fund, assuming you’ll manage the risk from then on. This difference will impact your allocation over the entire time period. However, both become more conservative over time.

Summary

So, are target-date funds a good investment for you? That depends on your individual financial situation. This type of fund may be an appropriate investment for some investors, but not for others. As with any investment, get familiar with the specifics of the fund to make sure it fits in with your overall investment plan.

Austin Stagman is an Investment Analyst with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at bedelfinancial.com or email Austin.

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