Is a Target-Date Fund the Best Choice?

Reviewed by David KindnessReviewed by David Kindness

Target-date funds are a popular choice among investors saving for retirement. However, will a target-date fund give investors the income they desire? There are pros and cons to choosing a target-date fund.

Key Takeaways

• Target-date funds create a passively indexed portfolio that automatically rebalances based on an investor’s time until retirement.
• Target-date funds limit investment choices and decisions.
• These funds usually have a one-size-fits-all strategy.

What Is a Target-Date Fund?

An investor’s anticipated year of retirement is the “target date” of a target-date fund. This type of fund works best for those who can estimate their retirement age and year. Many financial institutions offer target-date funds. The fund names are transparent, like Fidelity Freedom 2050 (FFFHX), which targets individuals who plan to retire in 2050.

Each fund commonly invests in a portfolio of assets, aiming for growth while reducing risk. As individuals get closer to retirement age, the asset allocation becomes more conservative to preserve wealth. A target-date fund is like an automatic portfolio manager that makes weighting adjustments for the investor over time.

In 2023, 64% of retirement contributions were invested in target-date funds, up from 59% in 2022, according to Vanguard. Target-date funds have become a default option for many employer-sponsored 401(k) plans. The Pension Protection Act of 2006 helped employers develop retirement plans and set up employee automatic enrollment, making target-date funds an easy option for retirement plans with their low fees and diversified portfolios.

Warning

Investors should evaluate the costs of target-date funds among companies and funds. For example, the expense ratio of the Vanguard Target Retirement 2050 Fund (VFIFX) is .08%, while the expense ratio for the Fidelity Freedom 2050 Fund (FFFHX) is .75%.

Advantages and Disadvantages

Pros

• Handle rebalancing of assets automatically

• Easy enrollment process for employees and employers

• Funds provide full diversification

• Best for passive investors

Cons

• Target-date funds may be too conservative near retirement date and forego returns

• Fees vary among funds

• Individuals are not actively involved in investment choices

• Employees with varying income levels and professions are offered the same plans

Investing Alternatives

According to Vanguard, target-date fund investors are four to five times less likely to engage in trading and active account management than other investors. Financial situations differ by individual and some investors do not have an employer plan that defaults to a target-date fund. These individuals can choose a target-date fund through a financial institution or save for retirement with options such as:

• Mixed Portfolio: Investors can choose to invest a portion of retirement savings into a target-date fund with an employer 401(k), but independently and actively manage other types of investments with the help of a financial institution or advisor.
• Index Funds: These funds are not actively managed, meaning securities are not bought and sold by a portfolio manager as in the case of actively managed mutual funds. Investors can choose a stock index fund and a bond index fund and make weighting adjustments on their own or with the help of a financial advisor.
• Risk Management: At the beginning of a career, investors may choose to invest in a higher percentage of higher-risk stocks. As they get closer to retirement, wealth preservation becomes more important. Investors can reallocate their investment holdings to fixed-rate investments such as bonds. The fixed interest payments from bonds create a steady income and reduce volatility or price fluctuations in the portfolio.

Important

Retirees commonly count on IRAs, 401(k)s), Social Security, and savings to generate retirement income. Investing, including building a diversified portfolio, can help attain long-term financial goals.

Who Benefits Most From a Target-Date Fund?

Target-date funds benefit investors who do not follow investment markets, learn how to invest, and take a hands-on approach to their retirement. They’re even a smart move for people inclined to frequently change their fund allocation inside their 401(k). Target-date funds help to keep people disciplined in their investment choices.

Can Individuals Choose Multiple Funds With Different Target Dates?

Those who choose a target-date fund should make it the only investment in a 401(k). Many 401(k) holders try to use them to complement other funds, but they aren’t designed for that. It is also a mistake to spread out investments between a few target-date funds, a common misstep.

Are Target-Date Funds Regulated?

The U.S. Department of Labor (DOL), the Office of the Comptroller of the Currency (OCC), and the U.S. Securities and Exchange Commission (SEC) are tasked with overseeing the management of target-date funds using disclosure requirements, enforcement, and examinations.

The Bottom Line

Target-date funds are a common investment option for 401(k) accounts. Individuals choose a fund that matches their year of retirement. The fund will rebalance assets automatically until that target date.

Read the original article on Investopedia.