Investing is one of the most effective ways to build wealth. Since 1880, the S&P 500 has returned an average of 9% each year. Although short-term volatility means that any year might see larger gains or losses, over decades, you have a better chance of earning the average return.
But what if the market drops right when you plan to retire? You could lose a significant amount of your retirement funds just like that.
You can manage risk from market drops as you near retirement age by diversifying your investments between stocks and bonds and adjusting the balance between the two asset classes in your portfolio. The problem is that rebalancing your portfolio can be complicated, and you need to be vigilant about doing it. Also, some brokerages and mutual funds charge fees when you buy and sell investments, adding additional cost.
Target-date mutual funds aim to do the work for you, rebalancing your portfolio as you near retirement to make sure a significant drop in the market doesn’t ruin your retirement savings.
What Is a Target-Date Mutual Fund?
A target-date mutual fund is a type of fund explicitly designed for retirement savings.
Typical advice for retirement savings is to reduce your investment in stocks as you get older, increasing the amount that you invest in bonds. This tends to reduce the volatility in your portfolio. A good market adds less value to your investments, but a weak market won’t cause as many losses.
Manually tracking and rebalancing your portfolio as you age can get complicated, so target-date mutual funds do it for you. You can look at a list of target-date funds and choose one with a target date close to when you plan to retire. For example, if you want to retire in 2053, you could select a target-date 2050 or 2055 fund.
Target-date funds usually invest in a mixture of stocks, bonds, and sometimes cash. When the target date is far away, its managers weigh the portfolio heavily toward stocks. Each year, as the target date gets closer, the managers rebalance the portfolio by decreasing the stock holdings and increasing bond holdings to reduce volatility.
This makes it easy to save for retirement without managing your asset allocation or multiple investments by yourself. You can put your money in a single fund and let the fund managers do the work for you.
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What Is Asset Allocation?
Asset allocation is a term people frequently use when discussing their investment portfolios.
Your portfolio’s asset allocation is the portion of your money that you commit to different investments. For example, you might split your money between stocks, bonds, and cash. Depending on the exact split between the types of investments, your portfolio could have a very different performance.
Consider these two example portfolios using the same three asset types.
Portfolio 1 offers much higher potential returns but also higher risk. Portfolio 2 owns more conservative investments, so it won’t see the same gains but should perform better in a weak market.
Choosing an asset allocation based on your risk tolerance and when you plan to use the money in your portfolio is essential. Even if you have the same investments, balancing the amount of money you invest in each can make the portfolio serve many different goals.
How Do Target-Date Mutual Funds Work?
Target-date mutual funds work similarly to other mutual funds, but there are a few key differences to keep in mind.
What Target-Date Funds Invest In
Typically, target-date funds are like index funds. They don’t focus on a specific industry or section of the market. Instead, they buy and hold shares in an entire index of stocks, such as the S&P 500, and aim to replicate its performance. They also invest in a bond index and use that to make up the less risky portion of the portfolio.
Rather than going through the effort of buying individual stocks and bonds to track the index, many target-date funds purchase shares in other mutual funds.
For example, Vanguard’s target retirement funds hold shares in four other Vanguard funds:
- Vanguard Total Stock Market Index Fund Investor Shares
- Vanguard Total International Stock Index Fund Investor Shares
- Vanguard Total Bond Market II Index Fund Investor Shares
- Vanguard Total International Bond Index Fund Investor Shares
By investing in existing index funds, target-date fund managers don’t have to focus on building a portfolio of individual stocks to track an index. They can build a diversified portfolio that includes domestic and international equity and bond funds easily. They leave the more detailed fund management to the managers of other funds and instead focus on maintaining the appropriate asset allocation and rebalancing as necessary.
How Target-Date Funds Adjust Their Asset Allocation
Mutual fund managers can adjust their asset allocations in a few ways.
One is by using newly invested funds to purchase assets that the portfolio currently underweights. If the target for a fund’s asset allocation is a 70/30 split between stocks and bonds, and the portfolio currently sits at a 68/32 split, the managers use new funds to buy shares and bring the allocation closer to the target ratio. In this case, the fund manager would use any newly invested money to buy a few extra stocks.
The second method for rebalancing is to fund withdrawals by selling investments the portfolio currently overweights. Using the same example as above, the manager could sell bonds to fund withdrawals to reduce the portfolio’s bond holdings and bring the balance closer to the 70/30 goal.
Finally, the managers could sell some of the fund’s bonds and use the proceeds to buy stocks regardless of your investments or withdrawals. The downside of this is that it incurs more transaction fees for the fund.
Typically, fund managers rebalance using new investments or withdrawals to keep fees low.
Over time, the target balance between stocks and bonds changes. Typically, funds increase their bond holdings and decrease their stock holdings as the target date approaches.
Each fund provider sets different goals for its target-date funds. Some might be more aggressive, holding more stocks even as you near retirement. When selecting a target-date fund, look at multiple fund providers and choose the one that has a plan for adjusting its asset allocation that matches your risk tolerance.
How to Use a Target-Date Fund to Save for Retirement
One of the best parts of target-date funds is that they’re among the easiest ways to save for retirement.
To get started, all you have to do is choose a target-date fund you want to use and make an initial investment. Choose a fund with a target date that matches your expected retirement date and preferred asset allocation. Many funds have a minimum investment, which ranges from a few hundred to a few thousand dollars.
Once you’ve made your initial purchase of the fund, you can add additional money whenever you’d like. You can set up automatic weekly contributions or just add money as you have some extra left over at the end of the month.
Investing through a retirement account, like an IRA, can net you tax incentives that make reaching your retirement goals even easier.
When you retire, you can use the money in the fund to pay for your living expenses. Many target-date funds pay quarterly dividends, and you can use that cash flow as retirement income. Whenever you need extra money, you can sell some shares. It’s just like making a withdrawal from your savings account.
Advantages of Target-Date Mutual Funds
There are many reasons to choose a target-date fund.
- Simplicity. Target-date funds are one of the simplest places to put your retirement funds They’re an all-in-one solution. You don’t have to pick and choose individual securities or worry about maintaining a specific asset allocation. Instead, you keep purchasing shares in the same fund, and the fund managers handle the rest for you.
- Availability. Target-date funds have gained a lot of popularity in recent years. Many employers offer them in their 401(k) or other retirement plans. In addition to being available in retirement plans, most major mutual fund companies such as Fidelity, Vanguard, and Schwab offer their own line of target-date funds, making it easy to use one regardless of where you hold your investments.
- Diversification. Making sure you don’t keep all of your money in just a few stocks is essential to reducing your investment risk. The typical target-date fund is actually a fund of funds. The target date fund sown shares in index funds that hold shares in hundreds or thousands of businesses. Buying shares in a target-date fund provides instant diversification for your portfolio with little effort on your part.
- Adaptability. When you’re young, you can take a chance by putting most of your money in stocks and weathering bad markets in search of better returns. As you age, however, preserving your capital becomes more important, so you want to increase your bond holdings to reduce volatility. Target-date funds automatically adapt their strategies as you age to serve your changing needs and investing goals.
Drawbacks of Target-Date Mutual Funds
Target-date funds aren’t without their disadvantages, which you should know before you decide to invest in one.
- Less Control. If you invest in a target-date fund, you lose some control over your portfolio and its asset allocation. You rely on the fund managers to adjust the fund’s mixture of stocks and bonds for you based on what they think is best. Make sure you agree with the fund’s plan for adjusting the portfolio’s balance of stocks and bonds (also called a glide path) as you age.
- Less Flexibility. Using a target-date fund, especially in a taxable brokerage account, makes it harder to adjust your strategy on the fly. If you decide to change your investment mix, such as by reducing your weighting in stocks, you have to sell out of the target-date fund. Then, you can buy one that holds more bonds or build a portfolio using multiple mutual funds. If you have to sell out of a fund entirely in a taxable account to adjust your asset allocation, you could face significant capital gains taxes. In a tax-advantaged account such as a 401(k) or IRA, this is less of an issue because sales don’t trigger capital gains taxes.
- Fees. Like all mutual funds, target-date funds charge a management fee. This fee, also called an expense ratio, is typically a percentage of the assets you have invested. Fees can be a significant drain on your portfolio’s returns, so look for a fund that keeps costs low.
Investing is an essential part of saving for retirement, and target-date funds are one of the easiest ways to do it. You give up some control over your portfolio and the flexibility to make changes to your investment strategy, but you make up for it with the ease of investing. All you have to do is buy shares in one fund and let the managers do the rest.
If you’d rather take a higher-tech path toward making investing easy, consider a robo-advisor like Betterment instead. Robo-advisors tend to be more expensive than target-date funds but are far more flexible, letting you work toward financial goals beyond retirement. They also offer benefits like tax-loss harvesting and active investing options that may help you beat the market.