Planning for the future can sometimes feel like you're trying to hit a moving target, especially when you're balancing today's needs with tomorrow's dreams. It's completely normal to want an investment strategy that feels secure and manageable without requiring you to watch the stock market every single day. We're here to walk you through how target-date funds work so you can decide if they are the right tool for your journey.
What is a target date fund?
A target-date fund (sometimes called a lifecycle fund) is an all-in-one investment portfolio that automatically adjusts its risk level as you approach a specific retirement year. They have been a mainstay of personal finance for nearly thirty years, especially with employer retirement plans such as a 401(k). According to the Investment Company Institute, 90% of 401(k) plans offer target date funds among the investment options for participants.
They are built to help you assume greater risk in your younger years when you have time to recover from market dips, and then they gradually adopt a more conservative approach as you near retirement. The idea is straightforward: to accumulate assets for a specific retirement goal, hence the term "target date."
Most of these funds work on a traditional portfolio management approach where you select a fund with a year that aligns with your anticipated retirement. For example, you might choose an "XYZ 2035 Fund."
Over time, the fund rebalances to adjust the risk profile as that date approaches, aiming to achieve the desired investment return without you needing to manually move money around.
How do target date funds adjust asset allocation?
Asset allocation is a term that often comes up when we talk about these funds. But what does it actually mean for your money?
In its simplest form, asset allocation refers to how a fund divides its assets among various types of investments. These usually include stocks, bonds, and other investments known as asset classes.
This is the standout feature of target-date funds. They aim to balance risk and return by adjusting this allocation through time. As time goes on, they gradually shift to a more conservative approach by doing three main things:
- Increasing the proportion of fixed-income investments like bonds or cash
- Reducing exposure to riskier assets, like equities
- Adjusting the mix of equities or bonds toward lower volatility segments.
As your target date approaches, the holdings become more conservative. This strategic balance is designed to protect your portfolio as you get closer to needing those funds for retirement.
What is a “glide path”?
The term "glide path" might sound like aviation jargon, but it's a crucial component of this strategy. The glide path refers to the evolution of the fund's asset mix over time. It represents the transition from a greater emphasis on stocks to a greater emphasis on bonds as your retirement date draws near.
The primary benefit here is risk reduction. As you near retirement, you likely want to take on less risk with your investments. This gradual transition from riskier assets to more secure ones attempts to achieve a progressively conservative strategy.
How to compare costs and strategies
Not all funds are created equal, and they can vary widely in terms of cost and investment strategies.
Expense ratios and fees
A fund's expense ratio is the total annual cost an investor pays, represented as a percentage of assets in the fund. According to Morningstar, the average asset-weighted target fund expense ratio in 2024 was 0.30%.
To put that in perspective, using that average cost of 0.30% as an example, if you invest $100,000, you would pay $300 annually in fees.
These expenses will vary, especially when comparing mutual funds vs. ETFs. Mutual funds tend to be more expensive due to their active investment approach, while passively managed ETFs are generally cheaper. Even a slight percentage variance in fees can accumulate over time, significantly impacting your returns.
Investment strategies
Apart from fees, the strategy matters too. Some funds may follow an active management strategy, where professional managers actively conduct research and make strategic decisions. Others might follow an index-tracking strategy, aiming to replicate the performance of a market index.
There are also hybrid strategies that combine features from both. Regardless of the strategy, it's important to remember that no single approach guarantees superior performance. Selecting a fund that aligns with your specific goals and risk tolerance is crucial.
What happens when you reach the target date?
Contrary to what some might think, a target-date fund doesn't always stop adjusting its asset allocation or cash out at the target date. It depends on whether the fund uses a "to" or "through" approach:
- "To" funds: Tailored for investors who plan to begin withdrawing assets at retirement. The fund typically reaches its most conservative allocation right at the target date and generally stops adjusting.
- "Through" funds: Tailored for investors who anticipate investing beyond the target date. The fund maintains its gradual transition to more conservative holdings over time, addressing the need for continual investment management.
The limitations of target-date funds
According to the same Investment Company Institute survey, 30% of all 401(k) plan assets are invested in some kind of target date fund. For many investors, target-date funds are the default choice in these kinds of plans. They do have advantages. It is sensible for most investors to get more conservative as you get closer to retirement, and these funds take care of that transition for you.
However, there is a potential flaw: It assumes your financial situation is identical to everyone else retiring that year. But you are not the "average" person, and a rigid glide path fails to account for the dynamic nuances of your real life:
- Retirement Flexibility: What if you decide to work five years longer? Or retire five years early? The fund's "glide path" won't know that.
- Outside Assets: Do you have a pension? An expected inheritance? A spouse with a high income? Target-date funds operate in a vacuum, completely ignoring the rest of your financial picture.
- Risk Capacity: If you have a significant savings surplus to your needs, you might be able to afford more risk (and potential growth) than the fund allows. Conversely, if you have a medical issue requiring liquidity, the fund might be far too aggressive.
If you have no other choice, a target date fund is 'good enough.' But when it comes to your life savings, you shouldn't aim for 'good enough.' You should aim for a strategy tailored to you.
The Facet difference
Target-date funds can be a suitable option if you're looking for a hands-off, diversified approach to retirement savings. They offer the convenience of automatic asset allocation and cater to general risk tolerance levels.
However, at Facet, we believe your money is a reflection of your specific values and life circumstances. A target-date fund operates on a rigid timeline, but your life is dynamic. We take a member-first approach with a flat-fee membership that covers your entire financial life, not just your investments.
We help you build a comprehensive financial roadmap that accounts for your taxes, insurance, and personal goals, and offer access to estate planning services through our partnership with wealth.com (separate fees apply). While "good enough" might get you to retirement, a personalized strategy helps you thrive when you get there.
