Target date investment funds are an increasingly common option in many employer retirement savings plans (such as 401ks and 403bs). Yet despite their prevalence, not everyone understands exactly what they are and how they work, so this episode is dedicated to a deeper dive. We start out by explaining what target date funds are, switch gears to discussing the pros and cons of them, and finally wrap up by sharing our overall perspective on the people/situations for which they do and don’t make sense. Our goal is to provide a framework for evaluating whether or not target date funds may be right for you.
Outline of this episode
- What are target date funds? [1:11]
- Diving into the benefits [5:13]
- Drawbacks of target date funds [8:25]
- Our overall take on target date funds [15:18]
- The recap [18:36]
Understanding target date funds and how they work
Target date funds are investment funds, either in the form of a mutual fund or an ETF, that get more conservative over time by automatically decreasing their exposure to stocks and increasing their exposure to bonds as time passes. Each fund has a date or year associated with it that corresponds with the year you expect to retire. If you're just starting out in your career you might have a target date 2055 fund, while if you're later in your career you may have a target date 2025 fund.
The idea behind target date funds and how they work aligns with one of the principles of investing we've discussed on the podcast, which is matching your investment allocation (or risk) with the time horizon you're investing for. The concept is that longer investment time horizons lend themselves to a more aggressive investment mix (more stocks and fewer bonds) since you have plenty of time to ride out the ups and downs of the stock market while capturing the higher expected long-term returns of stocks. While conversely the shorter the time horizon, the more conservative the investment mix since you want less portfolio volatility and less risk of a temporary decline if you need to use the money within a shorter time period.
Does the good outweigh the bad when it comes to target date funds?
Some of the key positives of target date funds include their simplicity, diversification, and their ability to reduce risk as your investment time horizon shrinks. They also allow people to manage their investments using a "set it and forget it" approach.
While they do have many positives, they also have some drawbacks, the biggest one being a cookie cutter approach in terms of not being customized to your unique situation and removing your ability to control and rebalance your investments. This can cause problems by producing the wrong investment allocation for your situation and forcing suboptimal adjustments to your investments during certain market scenarios.
When it does (or does NOT) make sense to use target date funds
Situations where target date funds can be a good option include the accumulation phase of retirement savings (especially earlier in your career) for people with no interest, desire, or ability to manage their investments, as well as 529 college savings plans where the account balances and investment time horizons tend to be smaller.
On the flip side, target date funds often don't make sense if you have the skill to be able to choose and manage your own investments, or if you work with an advisor who can help you do that, and they can become an issue during the retirement transition and in the decumulation phase of retirement where you're withdrawing from your investments.
Resources & People Mentioned
- Podcast episode #3: The 80:20 Rule of Investing
- Podcast episode #19: The “Other 20%” of Successful Investing
- Download our guide: The Toolkit for Optimizing Your Finances as an Employed Physician
- Download our guide: The Financial Checkup