Target-date funds first hit the market in the early 1990s and have become much more popular in recent years. Target-date funds are most popular with investors focused on retirement planning. The level of risk exposure decreases over time as retirement nears. This type of fund will automatically change your asset allocation as you age.
Target-date funds do not provide a guaranteed return and limit themselves to investing in mutual funds.
These funds invest primarily in stock funds during the early years and become more conservative over time. The fund will divest itself from stocks gradually and invest in more income- based investments, including various types of bond funds.
Target-date funds attempt to simplify the complex task of investing over 30 years or more.
￼￼The Pension Protection Act of 2006 made target-date funds the default investment for many pension and 401(k) plans. If you fail to direct your employer-sponsored retirement plan, you’re probably invested in a target-date fund.
Target-date funds have several advantages:
1. The fund takes responsibility for rebalancing your assets.
While many investors put a lot of effort into investing their money at the beginning, many fail to continue giving their investments the necessary time and energy.
‣ Are you willing to reallocate your money each quarter? As your assets change in value, it’s necessary to keep your investments balanced.
‣ As your retirement dates nears, it’s also important to rebalance your portfolio in favor of lower-risk investments.
2. Target-date funds were designed to be your only retirement investing vehicle.
Rather than investing in several stocks, mutual funds, and bonds on your own, target-date funds can do all of this for you. You can plow all of your investment dollars into these funds.
3. You have options regarding your risk tolerance.
Not all target-date funds are the same. Funds with the same target dates can have very different allocations of stocks and bonds.
‣ There are generally three risk options for each target date.
4. The minimum investment is quite small.
Even the most modest of deposits is enough to get your investment started.
There are several advantages to target-date funds, especially if you’d rather leave the details to a professional money manager. Investing wisely requires time and energy that many hardworking investors don’t have. If you’re uncertain about how to invest appropriately for your retirement needs, a target-date fund is one possible solution.
￼￼But this type of investment isn’t a perfect answer for all future retirees. There are a few potential pitfalls, too.
Consider these disadvantages of target-date funds:
1. Many funds don’t rebalance often enough.
It can be a few years before a target-date fund rebalances your investments.
2. It’s difficult to accurately compare different funds.
Differences in fees, asset allocation, risk profiles, and performance measurements make fund comparison very challenging. It’s much more difficult to compare these funds than two large-cap funds.
3. These funds are too generic to match the needs of every investor.
A fund designed to meet the needs of everyone can’t be a perfect match for all investors.
4. The expenses can be higher than that of other types of funds.
On top of the management fee charged by the target-date fund, the funds in which they invest can also charge management fees.
5. There can be a lack of diversification.
Some target-date funds limit their investments to a few funds.
￼￼The disadvantages are real, but may not be an issue for you. Compare the list of advantages to the disadvantages and determine if a target-date fund is right for you.
Choosing a target-date fund can be more challenging than comparing other types of mutual funds. There are over 600 choices, and while many funds appear to be very similar, the details can make all the difference.
Keep these points in mind when choosing a target-date fund:
1. Determine your likely retirement date.
If you plan to retire in 2040, choose a fund with “2040” in the name.
2. Would you rather have a fund that invests in mutual funds that are managed actively or passively?
A few target-date funds only invest in index funds. Others limit themselves to active funds or utilize both.
‣ The funds that stick to index funds are more popular. This makes sense, given that the management fees are lower, and index funds tend to outperform actively managed funds.
3. Compare the fees.
The lowest fees in the industry are below 0.2%. At the high end, the fees approach 2.0%. Compare the fees you’ll be paying to the expected return.
‣ Fees can have a significant impact on your final return. Will a fund with fees of 1.8% outperform a 0.2% fund by 1.6%? It’s doubtful.
‣ If two funds can be expected to provide the same return, the fees may be the most important variable.
4. Compare the level of diversification.
Does the fund invest in international stocks? How diversified are the mutual funds held by the target-date fund?
‣ What percentage of the portfolio is held in stock funds versus bond funds? How will this percentage change over time? Are you comfortable with these numbers?
5. How large is the fund?
Some target-date funds have closed due to their size. If you invest in one of the larger funds, you may face the same fate. Will it bother you to open a second account with another firm in the future?
Target date funds are mutual funds that morph as your retirement target date approaches. Early in the process, the fund invests in stock-based funds. As retirement nears, the investments are more heavily focused on bond funds. This reallocation of funds happens slowly over time.
Most investors understand the need to reallocate their investing dollars as retirement approaches. A target-date fund will keep you in the appropriate level of risk until retirement. If you’re not interested in actively investing in your retirement, a target-date fund is a reasonable alternative.
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