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Target date funds are a great way for investors to gain exposure to retirement investments which match the risk-tolerance best-suited to where they are in their careers.  The funds allow investors to:

  1. accumulate higher-risk/higher-return retirement assets early in their careers
  2. 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 retirement plan 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 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:

  1. pick the fund closest to your intended retirement date,
  2. invest money across time,
  3. 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.

Because 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 some form of income.

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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.

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 through retirement

Target Date Fund Held To Retirement

target date fund to retirement example

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: (1) 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 and (2) 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.

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.

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 0.12% as an expense ratio.  The industry average expense ratio for comparable target-date funds runs 0.63% per their research.

Vanguard offers a number of target date index funds, but the ones of most interest to this site’s readers (young professionals/millennials) 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.

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 0.14%, 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.

Another options is T. Rowe Price, which provides Retirement Funds at similar price points to Fidelity’s Freedom Funds.  The company shows expense ratios ranging from 0.42%-0.72% when this was written.

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.

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.

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 need for a day trading guide or worries about receiving a margin call) than with active management, it can represent a more tax efficient investment.

Target Date Funds Pros and Cons

Pros

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 the 2019 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.  Possibly, target date funds may even invest in cryptocurrency in the future.

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 81% 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.

As an alternative, you can use a service like Betterment which uses index funds to replicate this same portfolio transition over time depending on stated financial goal.

Personally, my wife and I use Betterment for our IRA funds and have a glide path set which will transition our assets from primarily stock-based to fixed income as we age.  I aim to use the “through” target date fund methodology because my wife and I will want more exposure to equities in the long-term than fixed income.

In the later years, we will want more money to transition to fixed income as we retire completely and have need for income as opposed to capital appreciation.

Cons

Tax inefficient.  Depending on your investing style, 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.

Conclusion

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 S&P 500 index fund 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 account deposits 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.

Some of my favorite things to discuss include investing in index funds, how to save money, travel hacking with help from the Reddit churning (r/churning) community, house hacking and optimizing the benefits of my condo vs. apartment living, and tax topics like the earned income tax credit, common tax deductions,  tax reform in 2018, or other useful tax topics.  I want this to be a journey for us all to learn how to make a lot of money and pursue the lives we want.

Disclaimer

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 my the disclaimer on my About Young and the Invested page.

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