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This May Be The Only Investment You Need To Own

Financial Wellness

I have a confession to make.  I love sweets!  I am also a huge fan of simplicity and automation, especially when it comes to my finances.  What if I told you there is a “set it and forget it” type of investment that simplifies saving for retirement and your kids’ college?  It’s like receiving a Green Chef meal kit box vs. you deciding on the recipe and going to the grocery store to buy all the ingredients yourself.  I’m talking about target date funds.

Target date funds, also known as life-cycle funds, remove two major headaches for investors – asset allocation and periodic rebalancing of your portfolio.

Even though TDFs are simple investments, the devil is in the details.  So, let’s take a closer look at this type of investment and how to pick one that works for you.

What are target date funds?

Introduced in the early 1990s, TDFs are funds that own other index funds (“fund of funds”).  Investors choose a TDF with a date matching their anticipated retirement or the start of a child’s college years.  Target date funds (TDFs) mix several different types of stocks, bonds, and other investments to help you take more risks when you’re young, and gradually get more conservative in your investment strategy over time.  In other words, TDFs are designed to gracefully age with you.

For example, I’m in my mid-thirties.  Assuming I plan on retiring at the age of 65 (in 30 years), I would pick a fund that has 2050 in its name.  Most TDFs 2050 will emphasize growth by loading up on stock funds.  Over time, as I move closer to the target date, my TDF will be rebalanced to be more conservative (it’s called a glide path), with fewer equities and more fixed income funds.

As an illustration, let’s look at Vanguard Target Retirement 2050 Fund (VFIFX):  90.5% of this fund is invested in stocks funds and only 9.5% in bond funds.

If I were retiring in the next couple of years and owned Vanguard Target Retirement 2025 Fund (VTTVX), my portfolio would have 58% in stock funds, 41% in bond funds, and 1% in short-term reserves.

Are target date funds a good investment?

Even with good money habits in place, saving for retirement or college can be stressful and confusing.  Target date funds provide a simple and convenient solution for most individual investors.  You may already own it through your 401(k) because target date funds are the default choice for many providers of employer-backed retirement plans.

However, not all TDFs are created equal.  It’s critical for investors to understand what securities are in the fund, how a particular fund is designed to shift over time, and how much you’ll be paying in fees.

Target date funds pros and cons

(+) Lower risk through broad diversification

Some funds, like any of the Vanguard Target Retirement Funds, invest in broadest index funds, giving you access to thousands of U.S. and international stocks and bonds, including exposure to the major market sectors and segments.

(+) A professionally managed asset mix

The funds’ managers gradually shift each fund’s asset allocation to fewer stocks and more bonds, so the fund becomes more conservative the closer you get to retirement.

(+) Automatic rebalancing

The managers then maintain the current target mix, freeing you from the headache of periodic rebalancing.  Automatic rebalancing also saves you from yourself – in other words panicking with the crowd and buying high or selling low.

(+) Low costs

Not all TDFs are created equal and some have higher costs than others.  I’m a fan of Vanguard target date funds because their average expense ratio is 0.1% compared to the industry average expense ratio of 0.6%.

(+) TDFs help you manage the biggest long-term risk – inflation

Target date funds help you manage inflation by investing more heavily in stocks earlier in your career and therefore growing your savings past the point of inflation.

(-) TDFs do not reflect your particular circumstances

Target date fund is a simplified investment vehicle and it doesn’t fully reflect your personal and financial situation currently or in the future.

(-) TDFs are not guaranteed against losses

Target date funds contain stock and bond funds. The value of these investments will fluctuate and can go down, causing your investment in the target date fund to lose value as well.

(-) Reaching the target date does NOT guarantee that you’ve saved enough to meet your goal

This is related to a previous point.  Some investors assume that when they reach the target date on the fund, they will have enough money to retire or send their kids to college—but this is a false assumption. Whether or not your savings goals will be met will depend on many factors, including the amount of contributions you make in the fund over the years and the fund’s market performance.

How to choose a target date fund?

Here are some tips to help you select the target date fund that’s appropriate for you:

Pick the right target date

As mentioned earlier, investors typically pick the fund with the name closest to the date they plan to retire or send their kids to college.  For example, if your son is currently 8 years old, you would invest his 529 plan in a TDF 2030 fund, because he will start college 10 years from now.

Look under the hood

Funds with the same target date usually have a different mix of investments.  Look under the hood and see what you’re buying.  When comparing funds with similar target dates, examine their investment strategies so that you can select the one that best matches your tolerance for risk.  The asset allocation strategy may be too conservative — or not conservative enough.

What happens after the target date?

Make sure you understand what happens to your portfolio after the target date.  TDFs are designed to take you “to” or “through” retirement.

A “to retirement” target-date fund will reach its most conservative asset allocation on the date of the fund’s name. After that date, the allocation of the fund typically does not change throughout retirement.

A “through retirement” continues to rebalance and generally will reach its most conservative asset allocation after the target date. While these funds continue to decrease exposure to equities throughout retirement, they may not reach their most conservative point until the investor is well past age 65.

Upon reaching their target dates, some target-date funds merge into different funds that typically focus on generating income.

Check expenses and fees

Pay close attention to the fund’s fees and expenses.  Remember, they make a huge difference in the long-term performance of your portfolio.  The difference in price often revolves around whether the fund leans on cheaper passive investing strategies or more costly actively managed accounts.  You can compare different TDF fees and expenses using FINRA’s Fund Analyzer tool.

Keep an eye on the glide path of your TDF

Even though TDFs are marketed as a “set it and forget it” type of investment, I would still review your fund periodically to make sure the investment manager has not changed the way the asset allocation is changed over time.

Big picture view

TDFs are designed to be standalone investments.  If you have other investments in addition to TDFs, make sure you are comfortable with your overall asset allocation.  And of course, don’t forget to rebalance your overall portfolio regularly.

How do I purchase a target date fund?

Purchasing a TDF is very simple.  There are three ways to do it:

  1. If you have a 401(k) plan and never changed what’s in it, you most likely already own a TDF;
  2. You can open an online brokerage account with a fund manager or online broker;
  3. You can purchase the fund directly from a fund provider. The biggest players in this market are Vanguard, Fidelity, and T. Rowe Price.

There might be a minimum initial investment required – ranging from $1000 to $3000.  Some funds will waive that requirement for you if you set up automatic monthly deposits to your account.

The bigger picture

Some financial experts, especially the ones that get paid a percentage of assets under management, question the value of target date funds.  They say that a one-size-fits-all approach to investing isn’t suitable for every investor.

Others believe that TDFs can be a good way for individual investors to save for both retirement and college, as long as you pay attention to fees and risk profile.

There is elegance in simplicity.  If you are not excited to decide on the asset allocation, pick the right investments, and rebalance your portfolio regularly with discipline, consider learning if a target date fund is a right investment for you.

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