Target date funds are structured for traditional 401(k) portfolios to optimize risk and returns for investments, like mutual funds and exchange-traded funds (EFTs). Investors can select a target date for their returns, allowing the assets to be reorganized and optimized over time in order to meet the target.
For example, as an investor, if you would like to have funds by a specific year, then the portfolio manager will use the predetermined timeline – which is typically long-term – to form an investment strategy for your funds. Over time, the funds are optimized, which balance risk and return, allowing you to meet your target in the future.
Like everything in life, there are advantages and disadvantages related to target date funds, and the structure may not be ideal for every type of investor. Continue reading to determine if target date funds are right for you.
Advantages of Target Date Funds
Target date funds are great for investors who do not want to spend a lot of time managing their portfolios or making investment decisions. Some advantages to consider include:
- Professionally Managed Portfolio: A portfolio manager will both enroll you in the appropriate target date fund and manage your investments, optimizing your funds over time. This is a great choice for people who are not familiar with the market, or who do not have time to manage their own portfolios.
- Low Maintenance: Instead of choosing multiple investments for a portfolio, participants of a target date fund plan can rest easy knowing their money is working for them. Portfolio managers will enroll the participant in a target date fund that matches with their retirement goals. For example, if you are looking to retire in 2065, you will be enrolled in the target date 2065 fund.
- One-and-Done Approach: Many financial advisors recommend a target date fund being the only investment you have. The account is optimizing your investments for you, so if you have similar additional investments on the side, then they could skew your overall portfolio allocation. Before making changes, speak with a financial advisor about what makes the most sense in your retirement savings journey.
Disadvantages of Target Date Funds
Before enrolling in a target date fund, you should always consider the disadvantages of the plan first. Speak with a financial advisor to fully understand the potential, risk, and performance before making a decision. Below are a few things to consider:
- Unable to Customize: Target date funds remove customization from investment planning. For example, as someone enrolling in the target date 2065 fund, you have the same investment strategy and structure as everyone else within that fund. What makes sense as an investment strategy for one person will not always make sense for another, making it more standardized and less personalized.
- Unable to Manage: Adding and subtracting different investments is not something you manage yourself, meaning it’s not a good option for people who like to make their own portfolio decisions, especially if your needs and wants change over time.
- Higher Expense Ratios: Some target date funds have a fee structure for investments like mutual funds. Speak with your financial advisor to learn about the layers of fees associated with your portfolio to better understand what you may be subjected to.
- Lack of Flexibility: If you choose to retire early, there is no guarantee that your target date fund will have enough return for your everyday use, and because the fund is an investment versus an annuity, it may have underperformed and under delivered if you’re retiring earlier than expected. The fund also doesn’t account for inflation, risking your retirement readiness even further.
Enrolling in a target date fund is one thing, but paying the fees associated is another. When you enroll in an account, you will need to make an initial deposit, but because the cost of a mutual fund is known as an expense ratio, you will also have to pay fees for that percentage of your investment, and the fees are ongoing. Due to the fee structure, you will likely experience a lower return on your investments.
Before choosing a target date fund, make sure you understand the expense ratio. The fee structures range, and are dependent on the investment strategy used for the fund, such as passive and actively managed accounts.
If you decide that a target date fund is right for you, make sure you research the investment philosophies for the fund as well. Is the plan too conservative? Too risky? Perhaps it’s just what you are looking for. By doing your research and asking questions, you will be able to make a better decision about target date funds and if they’re right for you.
While the funds can be a great hands-off investment strategy, there are disadvantages to consider as well. Always speak with a financial advisor before enrolling in a fund to ensure you’re making the right decision for your future finances.