Target-date funds — also called lifecycle or lifestyle funds — are complete portfolios contained in one single mutual fund. It’s kind of like a capsule wardrobe for your retirement savings. It contains the right mix of clothing to get you through each season so you don’t have to think about what outfits to wear every single day.
The mix of stocks and bonds in a target-date fund is based on the investor’s planned retirement date. As time goes on, the investment mix shifts to an allocation that’s more appropriate for your age (ie. out of riskier, high-growth investments and into safer, lower-return assets such as cash and bonds).
Because the investments evolve to suit your needs at every life stage, a target-date fund may be the only retirement investment you need. They’re a set-it-and-forget-it solution for saving for retirement, and often the default investment choice in workplace retirement plans like 401(k)s and 403(b)s. At the end of 2019 there was more than $1.4 trillion sitting in target-date funds, according to the Investment Company Institute. Here’s more about how they work.
What are target-date funds?
All target-date funds contain a mix of investments including stocks, bonds, cash and sometimes other types of assets, such as real estate. The “target date” is the year you envision retiring. The number of years until that target date determines the exact mix of investments (asset allocation).
The portfolio rebalances to become less focused on growth and more focused on income as the target date approaches and eventually passes.
Roughly 80% of large 401(k) plans offer nine target date funds on average. – Investment Company Institute
Let’s say you plan to retire in 30 years. You’d look for a target-date fund with the year 2050 (or as close to 2050 as possible) in the name. Within a target-date 2050 fund, the investment mix would skew heavily towards stocks in the beginning since you can afford to take on more investment risk. (You have enough years before you need your money to weather the stock market’s ups and downs.) As the years go by, the asset allocation model becomes more conservative to lower the investor’s exposure to risk.
How do they work?
Let’s take a peek inside the holdings of a real-life lifecycle fund: The Fidelity Freedom 2050 Fund.
Today — 30 years from the target retirement date — roughly 90% of the holdings in the fund are invested in a mix of domestic and international stocks. The remaining assets are in bonds, T-Bills and money market funds. As you get closer to your 2050 planned retirement date, the exposure to stocks within the fund will be dialed down. (This slide into more conservative investments is called a “glide path.”)
Based on the holdings in the Fidelity Freedom 2025 fund, by the time you’re five years away from retiring, the mix in your target-date fund will look something like this: 55% in stocks (domestic and international), 37% in bonds and 8% in short-term debt and other assets.
The shift into more stable investments like bonds continues even after you hit your retirement date in order to reduce your exposure to risk. The fund continues to be managed to ensure that you maintain the appropriate balance of risk and reward, and are able to draw income from your portfolio.
How are they different from index funds or regular mutual funds?
There are three main ways target-date funds and other types of mutual funds differ: Diversification, the type of investments they hold and how the fund is managed.
1. They are more diversified: Although mutual funds are inherently diversified since they hold a wide range of stocks or other assets, they’re only diversified within a narrow range of investments.
For example, if you invest in an S&P 500 index mutual fund, you’re invested 100% in stocks since it holds shares in 500 of the largest companies in the U.S., but no bonds or cash. A bond fund holds only bonds. And a mid-cap growth mutual fund contains only companies that meet that particular criteria — mid-sized, publicly traded businesses that the mutual fund manager deems having a better-than-average potential for growth.
A target-date mutual fund holds a mix of all of these types of assets — stocks, bonds, cash, even real estate and commodities — providing you with complete diversification within a single mutual fund.
2. They don’t invest directly in stocks: Mutual funds are simply baskets to hold other types of investments. Index funds and regular mutual funds contain stocks that meet a particular criteria (e.g. are part of a benchmark index or match a fund manager’s strategic investment objective).
Target date mutual funds contain other mutual funds, which is why they’re often called “funds of funds.” Instead of buying individual stocks to give investors exposure to a particular segment of the market, lifecycle funds buy mutual funds that have already picked the best stocks for the job. It’s like buying pre-made dishes for your Thanksgiving spread versus purchasing the individual ingredients to make the meal.
3. Funds are managed differently: When you see the word “management,” immediately start looking for fees. All mutual funds have management fees (called expense ratios). It’s a percentage of your assets to pay for administrative and marketing costs and the people in charge of making investment decisions.
There are two main types of fund management that describe how much hands-on work is involved: Actively managed mutual funds and passively managed funds.
Index mutual funds are passively managed. Because they are solely designed to match the returns of a particular market index (the S&P, Dow, Nasdaq), there’s no need for a human to actively make buy, sell and hold decisions. Index funds merely hold the same companies that are included in that index. Because they require little human touch, they tend to have the lowest expense ratios. The asset-weighted average expense ratio for index funds is 0.07%, or 7 cents for every $100 invested, according to Investment Company Institute data.
Investors in their thirties have, on average, 20% of their IRA assets in target date mutual funds. – Investment Company Institute
Regular mutual funds are actively-managed. A team of fund managers is in charge of making investment decisions. These types of mutual funds have the highest expense ratios. (Remember, every dollar you pay in fees is a dollar that’s not invested and earning money for you.) The average actively-managed fund charges expense ratios between 0.1% to 1%, and as high as 2.5%. In 2019 the average asset-weighted expense ratio was 0.74%, or 74 cents for every $100 invested.
Target-date funds fall somewhere in between. Once the asset allocation mix is set and the appropriate mutual funds are chosen for the portfolio, active management is less necessary. The average expense ratio for target-date mutual funds is 0.37% (37 cents for every $100 invested), according to ICI.
You’ll still have a team keeping an eye on performance of the funds: When an investment within the fund grows or shrinks out of proportion to the others within the fund (by a predetermined amount, like 5% or 10%), the managers will adjust the holdings to bring them back in line. Same deal when it’s time to shift assets as a target retirement date grows near.
You, the investor, don’t have to do anything to keep your retirement portfolio on track. Hence the appeal of investing in a target-date mutual fund.
More on investing on HerMoney.com:
- Watch Out for These 401(k) Rule Changes
- This Account Can Help Women Save Their Retirement
- Your Portfolio Is Out of Whack. Here’s How to Rebalance It
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