High-performing assets earn the most money, and the old saying is true: higher risk can lead to higher rewards. But as you approach retirement age, you should tailor your portfolio to your age and have less risky assets.
That’s where target date funds come in. Target date funds are a mix of stocks and bonds in a single fund that automatically become less risky over time.
“They’re a simple way of investing with a single fund that adjusts the asset allocation mix over time to minimize risk,” explains Fernanda Novaes, Portfolio Manager at Intercontinental Wealth Advisors.
If your investment goal is to save for financial independence, you might want to invest in a way that matches your risk tolerance without any effort on your part, which is exactly what target date funds do.
So what are target date funds? Let’s look at what they are and how they work in practice.
What Are Target Date Funds?
When retirement is many years away, investing in riskier options like stocks and equities is what experts suggest. Then, as retirement gets closer, you should gradually introduce less risky assets, such as bonds and treasury notes. Target date funds do this for you automatically, with no rebalancing on your part.
If you choose a target date fund, choose one that’s closest to your anticipated retirement year. Our experts recommend broad-market index funds for most young investors.
“Target date funds are what we call a fund of funds, meaning they’re a mix of other funds that are chosen for you, like an S&P 500 or a Russell 2000 fund. If you don’t have the time or expertise to choose, it can be better to let the experts take care of it,” adds Novaes.
How Do Target Date Funds Work?
When selecting a target date fund, you’ll typically select the date that most closely matches your anticipated retirement year.
“If you want to retire in 40 years, you’ll want a 2060 target date fund. At today’s point in time, it will start with more stock and equity exposure and less fixed-income exposure,” says Michelle Katzen, Managing Director, certified financial planner, and CDFA at HCR Wealth Advisors. “Over time, that fixed-income exposure will become a larger part of that investment bucket while the equity piece reduces,” Katzen says.
The fund in this example would first focus on high-risk stocks with the potential for higher returns. As 2060 approaches, those investments will roll into lower-risk bonds that are less risky — and with lower returns. Katzen calls this the glide path. “It’s a mandate on how your fund will be invested so it’s very clear on day one that each year, it will get more conservative by reducing equity allocation and increasing fixed income allocation.”
Over the years, those shifting allocations might look like:
- 2020: 95% stocks, 5% bonds
- 2040: 80% stocks, 20% bonds
- 2060: 40% stocks, 60% bonds
The exact percentages will depend on the fund you choose, but the idea is to create an automatic path toward the year of your retirement.
Target Date Funds vs. Index Funds
Index funds are another investment option that offer broad exposure to the market without having to choose individual investments. But unlike target date funds, index funds track the overall market, a certain industry, or a specific stock type.
The difference is in the rebalancing.
“Index funds aren’t going to adjust the asset allocation for you. Whatever the fund is, it’s always going to remain in that asset. They’re not going to take into account that you need money in 30 years for retirement like a target date fund would,” says Novaes.
If you choose a high-risk index fund, it will always be high-risk — and potentially have higher returns.
Compare that with a target date fund which does change risk level. Getting away from higher-risk investments in the final years before retirement means you can lose out on higher returns toward the end of the fund, but it’s keeping your investment safe, which is what it’s intended to do.
Should You Invest in Target Date Funds?
The best choice for you is one that matches your investment goals, investment timeline, and risk tolerance level. A good investment strategy asks for diversification — and there’s no one-size-fits all solution.
In fact, millionaire investor and founder of Personal Finance Club Jeremy Schneider says if he could redo his entire $4.5 million investment portfolio again, he’d only invest in target date funds.
“The target date index fund is actually, truly the most optimal, simple, low-cost investment strategy,” Schneider tells NextAdvisor.
If you don’t know where to start or want to invest without thinking about your portfolio, a target date fund is an excellent choice. You can always shift to other funds whenever you want.
The most important thing is to start investing — and if target date funds provide the introduction, then that’s great.
If you make the decision to invest with a target date fund, the best choice is one that most closely matches your anticipated retirement year. For example, if you think you’ll retire around 2057, a 2060 fund would make the most sense for your timeline.