Target date funds make saving and investing for retirement seem like a breeze. But what’s the catch? Find out what makes these funds so powerful and where hidden danger lurks. Then, stop back for Part 2 to discover 3 unique ways you can incorporate target date funds into more advanced financial strategies.

Target Date Funds Overview

Target date funds are a special type of mutual fund investment product. Remember, mutual funds allow you to buy a large basket of underlying investments with a single purchase. They provide instant diversification at the click of a button.

Target date funds take the power of this concept a step further. Unlike a traditional passive index fund that tracks a benchmark, like the S&P 500, a target date fund does additional work on your behalf.

These funds automatically rebalance and allocate across asset classes. They dynamically balance returns with overall portfolio risk depending on an investor’s age and retirement goals.

For younger investors, target date funds invest in a more aggressive allocation. Think higher-risk equities with massive future growth potential. The long-term investment timeline for this demographic allows these portfolios to embrace greater volatility and uncertainty. The potential upside, over the course of many decades, outweighs the pain that inevitable crashes and dips will cause.

As investors age and near traditional retirement, target date funds swap riskier equity investments for more conservative investments like bonds and treasuries. The most conservative portfolio mix is finally reached during the year that an investor preselects as their “target date” for retirement. This all happens automatically.

The conservative allocation ensures that even if the stock market tanks, a significant portion of the portfolio will remain safe. As a bonus, the bonds and other fixed income investments in this conservative portfolio pay consistent interest rates to investors. This works well for retirees who can use this “fixed income” to replace their traditional salary.

Buying Target Date Funds

All of the major investment fund companies (Fidelity, Vanguard, Schwab, etc.) offer their own version of these funds.

If you’re investing through your 401K, you will likely be restricted to a single firm’s family of funds. However, if you’re investing with a Roth IRA, traditional IRA, or taxable brokerage account, you can pick which fund company to use.

As with any index fund, it’s typically ideal to minimize fees. As we’ve discussed, investment fees are one of the hidden parasites that can erode significant wealth over time.

With target date funds, I suggest doing some additional homework. You’ll want to more thoroughly evaluate how a specific fund’s automated rebalancing plan functions and the broader investment strategy that it employs.

The good news? One of my favorite finance thought-leaders, Paul Merriman, already published this beautiful piece breaking down the key factors to consider. After you give it a read, you should feel well-equipped to start your research.

As you compare funds, you’ll also notice that the fund options all have a number at the end of their names. For instance, take this Vanguard Target Retirement 2065 Fund. On Vanguard’s website you’ll see the same fund with 2060 at the end, and 2055, and so on…

This number represents the target year of your desired retirement. Simply pick the fund that corresponds to whenever you envision yourself ultimately riding off into the sunset.

The Drawbacks

Although these funds will position you better than 90% of the investing population, there are a few cautionary points to consider.

First, you forgo flexibility.

While target date funds do an impressive job providing broad exposure to a diversified range of assets, you lose the ability to tweak the plan according to individual preferences.

Perhaps you desire increased exposure to foreign equities, alternative assets, or specific sectors. This flexibility is not provided by a target date fund…the automated technology makes all of those decisions for you.

Many also criticize the fact that target date funds hold even a portion of young investors’ portfolios in bonds or cash since this could slightly dampen overall growth potential.

Finally, the fees charged on target date funds are often marginally higher than those charged for the basic index funds offered by the same investment companies.

For instance, the Vanguard Target Retirement 2065 Fund carries a .15% expense ratio. Alternatively, the Vanguard Total Stock Market ETF offers a .03% expense ratio. Granted, both of those rates are low on an absolute scale. But the most fee-conscious investors may wish to rebalance their portfolios manually to save these costs.

Key Takeaways

Target date funds represent set-it-and-forget-it investing at its finest. They are deceptively powerful and can serve a valuable role in almost any portfolio.

Thanks to these funds, the same foundational principles that professional advisors historically reserved for wealthy clients are now available to the masses. And the fund doesn’t stop here folks. Now that we’ve covered the basics, you’re prepared to go one layer deeper.

Come back next week for Part 2. We’ll discuss three unique ways that you can leverage the power of target date funds to accomplish more bespoke investing goals with similar ease!