Investing

What Are Target-Date Funds? How Do They Work?

by Patrick

What Are Target-Date Funds?

When we are young, we tend to take more risks. However, as we grow older, we become more conservative and take lower-risk options. Target-date funds (TDFs) –also known as a lifecycle, dynamic-risk, or age-based fund- exactly do just that; they mix several investment strategies to help you take financial risks when you are young and use your target-date fund when you reach retirement age.

Let me explain with an example. Suppose you are a 25-year-old employee and intend to retire at the age of 66. Therefore, you start to invest in a target date 2060 fund (or if you plan to retire in or near 2035, you pick a fund with 2035 in its name). This target date in the name of the fund (i.e., 2060 fund) is the approximate date that you -as an investor- plan to retire and withdraw your money. At that time, you will use that money (or target-date fund) to cover your retirement expenses, such as your child’s college tuition, bills, healthcare services, etc.

How Do Target-Date Funds Work?

TDFs Work Through Glide path and Diversification.

If you want to invest in a target-date fund, you probably hear the word glide path. It is an investment roadmap; It will take you all along the way (i.e., from the beginning of your career until retirement), mapping out a mix of bonds, stocks, and other investments that are appropriate based on the target date. Like an airplane coming for landing, the glide path allows your savings to make a gentle landing into retirement by reducing the market risk (moving from aggressive to conservative investments over time).

When we are young and new at our job, retirement sounds very far away. That is why the glide path starts with a diversified mix of stocks and lower portions of bonds. As time passes, the glide path reduces the stock mix and adds to conservative and safe investments (such as bonds, cash, and cash equivalents). In another way, a target-date fund’s gradual shift to more conservative investments is called the glide path.

What Is Diversification?

Diversification is an investment strategy. If one kind of investment (e.g., stocks) has a bad year, other types of investments (e.g., cash and bonds) might have a good year. Put differently, diversification is another word for the expression “do not put all your eggs in one basket.”    Target-date funds use a diversification strategy. They consist of a mix of investments and change investment strategies over time. For example, they invest heavily in stocks in the early years but getting more conservative as time goes on.

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Benefits and Risks of Target-Date Funds:

Pros Cons
It has a very simple and straightforward process: to put it more simply, it means that when you are young, you pick a fund and put it in it as much as you can. But, you can’t withdraw your money till you reach retirement age.  Therefore, TDFs can help people who are less financially literate. TDFs do not provide guaranteed income; The principal value is not guaranteed at any time, including at the target date. (Remember that like all investments, target-date funds can lose money if the stocks and bonds owned by the fund drop in value). Therefore, it is very important to monitor your investments and do a little research for better outputs.
It is a good way for long-term investments. Investors have to make appropriate decisions based upon their personality, needs, goals, credible research, and information, related expenses, etc. Therefore, TDFs may not be as simple as they appear.
It uses a diversification strategy (has a very diversified portfolio). TDFs hold a mix of stocks, bonds, and other investments. TDFs have related expenses that investors should take into account.
TDFs have a diversified portfolio; generally, investors have three choices according to their risk tolerance. People naturally have different features; they can be conservative, aggressive, or moderate risk-takers. These features and tendencies change as time goes on. As mentioned earlier, people usually become more conservative or moderate risk-takers when they grow older. TDFs provide this option for investors to switch to a different risk level. Sometimes only one fund company offers different TDFs. In this regard, it is very risky; investors have to know that they are entrusting all of their assets to a single fund company! Remember that target-date funds are not risk-free.

Several Tips to Know about Target-Date Funds:

  • In addition to choosing the right target-date fund, you should put the right amount of money into it. An under-funded nest egg will not cover your retirement expenses.
  • You have to practice and improve your trading and investment skills before entering a real market.
  • TDFs are not guaranteed against losses. However, they use diversification strategies. Thus, they are less risky than investing in individual stocks or bonds.
  • Take care to select a TDF that aligns most closely with the date you plan to retire.
  • Choose an investment strategy that best matches your risk tolerance.
  • Check related fees and expenses. Compare different target-date fund fees and expenses using FINRA’s Fund Analyzer.

Conclusion

Retirement is a new stage of your life that needs preparedness and planning. Planning for retirement starts with thinking about your retirement goals and retirement expenses. For this, you should have enough money to meet your needs at that time. TDFs are increasingly one popular investment option for your retirement period. They are structured to help individuals invest in low risky, well-diversified portfolios that rebalance over time for retirement goals. In fact, you are trading savings today for security tomorrow.

Target-date funds are one of the good ways for investing your money; there is no doubt that they are better than not investing at all. But, you have other investment options that may work better for you than TDFs. Therefore, it is a good idea to consult with an investing professional you trust. An investing pro can help you in choosing the right path for you. However, remember that the final decision should always be yours.

“If you have any feedback about what are target-date funds that you have tried out or any questions about the ones that I have recommended, please leave your comments below!”

NB: The purpose of this website is to provide a general understanding of personal finance, basic financial concepts, and information. It’s not intended to advise on tax, insurance, investment, or any product and service. Since each of us has our own unique situation, you should have all the appropriate information to understand and make the right decision to fit with your needs and your financial goals. I hope that you will succeed in building your financial future.