Target-Date Fund: What is it and When to Use It?

Target-Date Fund: What is it and When to Use It?

A target-date fund (TDF) is a fund offered by an investment company that seeks to grow assets over a specified period of time for a targeted retirement goal. For example, if you’re 40 years old and your target retirement date is still 20 years out, you’ll get a target-date fund of 2040. Most people are familiar with target-date funds as they are often offered as part of a 401k plan.

Target-date fund advantages

  • Are simple all-in-one solutions designed to be long term investments based on your retirement date. This allows some people to “set it and forget it”, eliminating the need to decide on a mix of assets.
  • Age with you by automatically rebalancing your portfolio from growth investments to more conservative ones as retirement nears.
  • Keep investors from being emotionally reactive to the market’s changes, which usually results in them trying to time the market and in fact, doing damage to their portfolios.

Target-date funds work well in certain situations. But under different circumstances, there may be better alternatives. Let’s take a look at some scenarios below.

Scenario 1: When Target-Date Funds Are a Good Idea

Let’s say you’re fresh out of college and just started your first job. You’ve been asked to choose allocations for your 401K plan, but you aren’t financially astute and your company isn’t providing you with any guidance. Target-date funds would work well in this situation.

Side note: Your company is doing the right thing by not telling you how to allocate your money. If they did, and you lost a lot of money, you could potentially sue them. Therefore, you can never expect guidance from your company about what funds to choose. 

Target date funds work well because you’re able to choose a target date near when you retire and will get instant diversification. While they’re less maintenance than other funds, be aware not all target-date funds are equal—some are better than others.

It’s important to research the types of funds you’re going to use, as they vary. For example, some are more expensive, some have better track records, better management, better allocations, etc. Therefore, target-date funds aren’t maintenance-free. You need to perform upfront research to choose funds that work best for you.

Scenario 2: When Target Date Funds Aren’t a Good Idea

Let’s say it’s 15 years from now. You’ve worked your way up the corporate ladder. You’re married with two children. You have a significant amount of money in your 401K. Unfortunately, the market isn’t doing as well as it was 15 years ago. At this point, you should reevaluate target-date funds.

A downside with target date funds are they aren’t customized to your situation nor do they take into account the financial climate. Why? Target-date funds are solely based on your target retirement date. That means someone who plans to retire when you do, but whose personal and financial situations are completely different than yours, will receive the same predetermined blend of stocks, bonds, and other asset allocations.

A better option might be using individual holdings and a more customized blend, based on your particular circumstances. Why? Target-date funds become more conservative the closer you get to your target retirement date. This means the funds use less stocks and more bonds. If you have a significant amount of money invested, you don’t necessarily want this situation to happen automatically. When there’s a market downturn, the last thing you want to be doing is selling out of stocks and buying into bonds. In fact, you’d want the exact opposite scenario or you’ll lose money.

Target-date fund disadvantages

  • They may be more expensive because it is a fund that invests in other funds. You may need to pay the fees of both the underlying assets and the fees of the target-date fund.
  • There is no guarantee that the earnings will keep up with inflation or generate a certain amount of income or gains. As an investment, there is always the risk of under-performance. If you set it and forget it, you may not realize it until it is too late.
  • All assets are not the same. The mix of assets can vary quite substantially depending on whether the fund opted for more domestic stocks or looked at more international investments.

If you get to the point where target-date funds don’t make sense for your situation, your best option is to consult with an expert. For the same reason you’d call a plumber to fix broken pipes, call a financial expert to help you with your retirement investment needs. They can not only create a comprehensive financial plan for you, but can also help you decide how to allocate significant amounts of money within your 401k plan.

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