Target date funds are a great way for investors to gain exposure to investments which match the risk-tolerance best-suited to where they are in their careers. The funds allow investors to:
- accumulate higher-risk/higher-return retirement assets early in their careers
- transition toward wealth preservation strategies by holding a higher allocation of less-risky, fixed-income investments
Companies like Vanguard, Fidelity, Schwab, T. Rowe Price and others offer these products through various tax-advantaged investment plans and after-tax brokerage accounts.
An important aspect to keep in mind for any investment is that they entail risk. Markets go up, markets go down. When that happens, your balance in the investment will naturally change.
That’s market risk and it’s just one type of risk you’re exposed to when you invest. There’s also interest rate risk, inflation risk, currency risk, and many more.
However, target date funds attempt to lessen the severity of some risk by gradually and automatically transitioning your asset mix of stocks and bonds to a more conservative mix as you approach retirement.
This is obviously a time you’ll need the money you’ve saved during your wealth accumulation phase and transitioned toward wealth preservation. Both are crucial components for reaching financial independence.
Because no two are the same (no cookie-cutting here), let’s learn more about these powerful products used by millions to prepare for a safe and secure retirement.
What are Target Date Funds?
Target date funds invest in assets which match the recommended risk preferences of investors with their intended retirement date. Depending on the age at purchase, the mix of underlying assets can comprise various allocations toward stocks and bonds.
Please note all funds are not the same. Most follow a similar strategy:
- pick the fund closest to your intended retirement date,
- invest money across time,
- have a fund manager adjust the mix of stock, debt, and cash to become more conservative over time
However, despite these simple steps, these funds can differ dramatically. This includes the investments held in each fund, various levels of fees associated with the fund and underlying investments, and even what happens with the investments from present to target date and beyond (“to” vs. “through”).
In fact, some funds cease the transition to more conservative investments at the target date while others transition slower and continue shifting toward more fixed-income/cash allocations. The advantage of the latter would be more potential for growth into your retirement years.
For target date funds to qualify as one of the best investments for young adults, I’d only consider the latter (“through” retirement) since continued portfolio growth in our later years is important. I say this because as things currently stand, we might not have as many retirement resources as our parents and grandparents with Social Security and Medicare currently slated to run out of money before we retire.
And let’s face it, despite reaching your goal, you might still need more capital appreciation going forward. If you consider the amount of time you’re likely to spend in retirement, which could be 30 years or more, it becomes clear a need still exists for capital growth from stocks and also some combination of income-generating assets.
How do Target Date Funds Work?
Target date funds offer the simplicity of investing in one product and having the asset allocation change over time as you age. This allows for a transition from more stocks to more fixed-income and cash-equivalent investments to match your recommended risk levels by age.
This transition, referred to as the “glide path,” can help investors who do not pay close attention to their retirement holdings across time. An investor need only select the fund best-matched to their intended retirement date and hold the investment.
This results in better tax consequences (discussed below) and eases concern by not needing to worry about rebalancing, asset selection, or any other investing due diligence.
Are Target Date Funds a Good Investment?
According to a CNBC article, one man who held employer-sponsored retirement accounts from 4 previous employers and one from his most recent employer, saw his losses would have been significantly less had all the assets been invested in an equivalent target fund in his most-recent employer’s retirement fund.
His previous employers’ retirement accounts heavily invested in stock portfolios and resulted in far steeper losses than he would have under a comparable stock/bond allocation in his target fund. Target date funds would have transitioned some of his funds from stocks to bonds and possibly resulted in smaller losses.
Looking at Morningstar’s data included in the article, we can see accounts held in funds closer to retirement performed less-poorly than those intended for later dates. This is because those later-dated target funds held higher allocations in equities and thus experienced more adverse returns during the recession.
For investors who wish to automate their retirement savings in diversified, low-cost passive investments, target funds can be valuable financial instruments. The funds automatically transition from heavier stock allocations to bond allocations as the employee ages, thereby taking less risk in their retirement portfolios.
If these types of investments interest you, consider opening an account with Firstrade. The service boasts over 11,000 mutual fund options and allows you to invest in a large number of target date funds.
Alternatively, you can use M1 Finance’s Dynamic Rebalancing service which steadily transitions your portfolio toward preset investment choices like my wife and I.
This service, which comes free of charge, can invest money in line with your desired portfolio as you age and likely choose to hold less in equities and more in fixed income or other lower-risk investments.
This will require you to log into your account periodically and transition your portfolio manually, though at a lower cost than many mutual fund apps like Charles Schwab, TD Ameritrade, E*Trade and Fidelity which charge commissions as high as $49.99 per trade.
For the free trades and greater investment account control, I personally recommend a more hands-on approach.
Read more in our M1 Finance review.
Are Target Date Funds Held ‘To’ or ‘Through’ Retirement?
Target date funds continue holding equities in a person’s portfolio when entering retirement. However, the allocation will depend on whether the investor has access to target date funds which transition “through” retirement or “to” retirement.
The former offers a greater allocation in equities because these funds understand the holder continues to seek capital appreciation through a higher stock allocation than fixed income investments. The latter holds a more conservative allocation.
More specifically, target funds inherently manage an investor’s assets in relation to an intended retirement date. With target date funds employing the “to” approach, this results in funds adopting higher allocations to fixed income investments at or toward the retirement date. The investor’s portfolio allocation will remain static thereafter.
Whereas with “through” retirement target date funds, the retirement date helps guide investors through retirement with the goal of accumulating wealth long after the retirement date. Funds which adopt this approach have higher stock allocations at the target date and follow with a decreasing allocation 10-30 years post retirement.
These fund approaches differ dramatically in terms of risk/return potential. Make sure you understand the risk/reward trade-off made through these funds and how they invest in stocks and bonds over time.
The charts below illustrate the differences in allocations to stocks and bonds in both a “to” and “through” approach. As you can see, both graphs show changes in allocations over a 50+ year period. The “to” approach emphasizes the static glide path (consistent slope of the change in allocation over time) while the “through” approach emphasizes a steepening decline in its glide path beyond retirement.
Target Date Fund Held Through Retirement
Target Date Fund Held To Retirement
What are the Best Target Date Funds?
Some target date funds, if low-cost, can be great for holding an entire retirement account’s portfolio. The reason for this is the underlying assets should be invested in low-cost index funds to provide diversification while also risk management through the glide path feature.
Make sure the fees in these target date funds do not eat away at your returns, however. If the fees far exceed 0.75% while alternatives available through your employer offer far lower fees for similar investments, it may make sense to take this management into your own hands.
Doing so, however, requires manually adjusting your allocation between stock and bond mutual funds/holdings across time. This also runs into complications with behavioral finance concerns.
→ Vanguard Target Date Funds
Choosing the best target date fund depends on the number of years to retirement but you will want to choose funds with lower costs. Vanguard, for example, offers all-in-one funds called Vanguard Target Retirement Funds and average 0.10% as an expense ratio (as of 6/1/2020). The industry average expense ratio for comparable target-date funds runs 0.60% per their research.
Vanguard offers a number of target date index funds, but the ones of most interest to this site’s readers (young adults) are likely the Vanguard Target Retirement 2050, 2055, and 2060 Funds (VFIFX, VFFVX and VTTSX, respectively). These funds all offer 0.15% expense ratios when this was written.
Vanguard keeps its expense ratios low by having passive index ETFs make up the assets held in the target date funds. The active component only comes when making the transition from stocks to fixed-income ETF holdings. Otherwise, the ETFs held in the funds track various broader market indices.
→ Fidelity Target Date Funds
Other companies offer options as well. Fidelity offers Fidelity Freedom Funds, which run higher in terms of expense ratios. From a brief review at the time of this writing, I saw Fidelity’s Freedom Funds run between 0.49%-0.75%. Despite the higher cost, these investments can still offer better suitable choices for those not interested in manually maintaining their portfolio.
Fidelity also offers its Fidelity Freedom Index Funds which come at a fraction of the cost. These all maintain expense ratios of 0.12% (as of 6/1/2020), much lower than the actively-managed Freedom Funds. These entirely-passive funds afford the lower expenses by having less intervention from active managers when making asset allocation decisions.
→ T. Rowe Price Target Date Funds
Another option is T. Rowe Price, which provides Retirement Funds at similar price points to Fidelity’s Freedom Funds. The company shows expense ratios ranging from 0.47%-0.71% (as of 6/1/2020).
My previous employer partnered with T. Rowe Price for our 401(k) plan and would default new employees into these target date funds when retirement benefits began accruing. Many employees likely remained in these funds with their retirement contributions.
→ Schwab Target Date Funds
Based on these three companies, Vanguard appears to offer the lowest average expense ratio for target date funds. However, Charles Schwab also offers target date index funds at more competitive expense ratios.
In fact, the company offers all target date index funds at a net 0.08% expense ratio, below all the above options. Much like Vanguard and Fidelity’s low-cost target date index funds, Schwab invests only in Schwab exchange traded funds (ETFs) and automatically transitions the underlying assets to reflect a more conservative portfolio as you near retirement.
Some popular target date index funds from Schwab are SWYHX (2045), SWYMX (2050), SWYJX (2055), and SWYNX (2060). Schwab achieves these low net expense ratios by primarily investing in low-cost, passive ETF investments from Schwab and uses little active management beyond gliding into more conservative allocations as the retirement date nears.
Schwab vs. T. Rowe Price vs. Fidelity vs. Vanguard Target Date Funds
→ Expense Ratios
Undoubtedly, over the long term, expenses matter a great deal. As a result, annual expense ratios affect your long term performance and should be something you consider when selecting the type of mutual fund you want to store and grow your wealth.
Some companies who offer target date funds have expenses which merely represent the roll up of a weighted average of the underling mutual funds’ expense ratios. In the case of Fidelity, T. Rowe and Vanguard, these companies merely pass these expenses through without layered active management fees.
To give you a flavor for how these companies’ expense ratios compare, have a look at the following table:
|Target Date||Schwab||T. Rowe Price||Fidelity||Vanguard||Category Average*|
|*Source: Morningstar Category Average as of 3/31/2020|
You can see that Vanguard has low expenses due to their use of low-cost index funds as opposed to active fund management. Schwab, Fidelity and T. Rowe all primarily rely on the use of actively managed funds for their target date mutual funds, and thus carry higher costs.
Of special note, however, is that all four fund families offer different share classes of their target date funds. This mans each class carries separate expense ratios. Schwab, Vanguard and Fidelity all offer low-cost index versions comprised of their respective index mutual funds.
→ Equity Percentage at Age 65 (Retirement)
Further adding diversity in these companies’ target date funds lineups is the percentage of underlying assets held in equities at retirement age (65). Given your investment objectives, you might wish to hold more or less equity in your portfolio at retirement, adding further complexity to your investment decision.
Looking at these four companies, the following table shows the respective equity percentage held in the target date fund families at retirement age:
|Target Date Family||Percentage of Equities @ 65|
|T. Rowe Price||55.40%|
|*Source: Charles Schwab (SWCRX), T. Rowe Price (TRRBX), Fidelity (FPIFX), Vanguard (VTWNX)|
→ Asset Classes Represented
Another important consideration for choosing between these target date funds is the underlying asset classes represented in each of the fund families. Have a look at the following table to see the asset classes held in each target date fund family.
|Asset Class||Schwab||T. Rowe Price||Fidelity||Vanguard|
|U.S. Large Cap||X||X||X||X|
|U.S. Mid Cap||X||X||X||X|
|U.S. Small Cap||X||X||X||X|
|Emerging Markets Equity||X||X||X||X|
|U.S. Fixed Income||X||X||X||X|
|High Yield Bonds||X||X||X||X|
|Emerging Markets Debt||X||X|
Are Target Date Funds Tax Efficient?
When investing in mutual funds and target date funds, you purchase a security comprised of underlying assets (mutual funds or ETFs). When these underlying funds realize capital gains and/or dividends, these pass through annually to the shareholder, who pays the applicable tax.
For net capital gains (capital gains less capital losses), they come grouped into two buckets: long-term (securities held longer than one year) or short-term (held <1 year). The IRS taxes both at the appropriate rates for the shareholder, and depending, could result in paying no tax.
For dividends, fund managers accumulate and distribute these to shareholders throughout the year. Dividends receive ordinary income tax treatment unless they meet the requirements for qualified dividends.
These distributions represent one form of taxation on target date funds. Investors can also transact by buying and selling the funds themselves, triggering another taxable event.
Commonly, target date funds are tax efficient in nature because they often require no transacting on your part to arrive at your asset allocation. As a result, the target date investor faces fewer taxable events than an actively-managed portfolio.
However, because capital gains and dividends pass through to the investor regularly, if an investor holds these investments outside of a tax-advantaged account, this can trigger regular tax consequences.
In other words, if the investor transacts less often with target date funds (no worries about receiving a margin call from shorting stocks) than with active management, it can represent a more tax efficient investment.
Are Target Date Funds Actively Managed?
Target date funds provide a simplified way to save for retirement. They offer exposure to a variety of asset classes, markets, and active and passive management (discussed below).
Regarding the active vs. passive management component, investors need to remain aware of the assets held in the target date funds. Said differently, despite the simplicity of these investments, investors must should be conscious of the underlying asset allocation, fees, and portfolio risk of their target date investments.
In fact, some fund companies offer two type of target date investments: target date funds and target date index funds.
Target Date Funds vs Index Funds
Fund companies can offer two types of target date funds:
- traditional target date funds which hold a mix of passive and active underlying mutual funds meant to transition toward more conservative mutual funds as the investor ages
- target date index funds which primarily invest in passive ETF investments from the fund company.
The former provides active fund management opportunities while the latter is primarily passive in nature. The active component results in higher expense ratios because this utilizes active managers who attempt to beat their relevant benchmark through stock picking or discretionary fixed-income selection.
Personally, I prefer the passive options for their cost and the removal of human emotion when it comes to decision-making. Having made some of my worst investing mistakes thinking I could beat the market, I opt for avoiding the uncompensated risk.
Regardless of choice, both types of funds offer diversification, asset allocation optimization, and rebalancing to keep on track if markets change.
Target Date Funds Pros and Cons
→ Get a complete portfolio in a single fund. By electing one target date fund, you have a straightforward approach to a sophisticated problem: how to invest successfully for retirement, whether in an individual retirement account (IRA), 401k, or other eligible retirement account. No matter the account type, be sure to take advantage of retirement plan limits.
→ Less risk through broader diversification. Each target date fund available through Vanguard, Fidelity, T. Rowe Price, Schwab or other companies invests in index funds which track the broader market. Available options give you access to thousands of U.S. and international stocks and bonds, including exposure to the major market sectors and segments.
→ Professionally-managed asset mix. Each target date fund has a manager who gradually shifts each fund’s asset allocation to a lower stock mix and more fixed income investments over time. This happens to make the investment portfolio more conservative the closer you get to retirement.
→ Automatic rebalancing. Because managers oversee these funds, they make sure to maintain the current target asset mix. This frees you from the hassle of worrying about ongoing rebalancing on a quarterly, semi-annual or annual basis. Essentially, the funds operate on a schedule laid out in the prospectus.
→ Low costs. Depending on your target date fund company, your costs can fall on the lower side than managing the assets yourself. For example, Vanguard offers expense ratios 83% below the industry average. When you pay less for your target date funds, this keeps more money for you and shows you just how to save money toward your retirement goals.
→ Tax inefficient. Depending on your investing strategy, target date funds can represent tax inefficient investments. Capital gains and dividends pass through to the investor and can result in tax consequences if held outside of a tax-advantaged account. For this reason, target date funds most commonly reside in tax-advantaged retirement plans.
→ Glide path variability. Depending on fund type, you might not hold the preferred allocation of stock, bonds, and cash. Some funds transition quicker or slower than your desired asset allocation. This can expose the investor to undue risk. Before purchasing a target date fund, take a closer look at the allocation, glide path, and whether the fund employs a ‘to’ or ‘through’ retirement methodology.
→ Higher fees. Make no mistake about it, these higher-touch products come at a higher cost. Quite often, target date funds can charge higher fees than mutual funds because they pass through not only the underlying mutual funds’ fees, but also their own management fees. Some target date funds come with over 0.80% of annual fees based on the numbers shown above. These fees can compound and make it harder to learn how to build wealth.
Personally, I am delighted to see many companies offer default investments into target date funds. If an employee never logs into the account once after being hired, these investments are deemed more suitable than purely company stock or equity mutual funds.
This is because the employee may have different risk preferences depending on where they are on their journey toward retirement. For example, defaulting a 22-year old employee into an total market fund like VTI or VTSAX is suitable, whereas a new 60-year old employee likely would not make the same decision.
When learning how to start investing money early in a career, these mistakes can be forgivable. When retirement is just around the corner, this requires more suitable financial planning.
Target date funds remove this concern if employers default their employees into these funds.
It is important to be mindful of the risks posed by markets, independent of the investments held in your account. The only truly risk-free investments are insured savings accounts, certificates of deposit or Treasury bonds and notes.
Being cognizant of the risks involved with investing is imperative. Target date funds do a decent job of managing the risk better for employees as they age and near retirement.
About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see the disclaimer on my About Young and the Invested page.