Think about it this way: You've started saving for retirement. When you're younger, you can afford to risk the savings on risky stocks that can quickly double or triple in value, because if there's a market downturn, you have a few years to make up the loss when the market is bullish again.
But as you age, you need to be more careful. If your savings take a hit you'll have less time to make the money back.
This is the logic of a target date fund.
What Is a Target-Date Fund?
Target-date funds help you save for retirement. They are also sometimes referred to as "target-date retirement funds" or "lifecycle funds."
A target-date fund is built out of a combination of assets, typically holding stocks, mutual funds, bonds and potentially other investments. The fund shifts its asset composition over time as the target date of the fund grows closer, changing according to a pre-determined investment strategy. A typical target-date fund will grow more conservative as it approaches this deadline, shifting its asset composition from higher-risk investments such as stocks toward more secure investments such as bonds and mutual funds.
As with any fund, a target-date fund is a collective investment. This means that you are buying shares of the larger portfolio and are one of many investors. (This is as opposed, for example, to purchasing stocks, in which case you are the sole owner of the stocks in question.)
You can invest in a target-date fund with ordinary personal capital or as part of your tax-advantaged retirement account. Many 401(k) plans offer target-date funds as an option.
Why Use a Target-Date Fund?
Investors use a target-date fund to weight risk.
The logic of a target-date fund is that younger workers can take more risks with their retirement accounts. When you're 35, you can afford a stock-heavy 401(k), with all its potential for profit, because you will (ideally) have at least 30 more working years to recoup investment losses due to volatility.
At 55, on the other hand, retirement is looming. You want safer investments because you've only got 10 working years left. You may not have enough time to wait for stocks to recover if a higher-risk investment goes wrong.
Most people working toward retirement share this risk profile. For them, a target-date fund offers to professionally weight, analyze and perform that risk calculation. Instead of you (personally) trying to shift your retirement investments according to best-guess risk calculations about your working years left and future earnings, the sales pitch of a target-date fund is that investment advisers will shift the risk for you.
How Does a Target-Date Fund Assess Risk?
This depends almost entirely on the fund.
Most funds will be built around specific retirement years. For example, a target-date fund called "Fund 2020" will have been put together with a risk profile for people retiring in 2020. So, if you are 25 right now, you might invest in a "Fund 2059" target date fund, built for people planning to retire in 40 years.
Over the next 40 years, then, this fund will gradually shift away from risker stocks and speculative investments that offer high returns and toward low-risk mutual funds, bonds and fixed-income assets that have lower but more predictable returns.
However, the exact process is fund-determined. Some target-date funds will use automatic benchmarks, moving toward specific asset mixes at pre-arranged times. Others might be manually adjusted, with a manager adjusting the fund as s/he judges best over time. Others might use a different metric altogether. It's important to understand exactly how your target-date fund will assess risk and adjust the portfolio composition before investing.
This is called the "glide-path," the exact mix of assets that your fund will use and how it will adjust that composition over time.
Then there are goals-based target-date funds. These are set up somewhat differently than traditional funds, as they are built both around time and specific financial targets. The targets might be established by the fund (for example, reach a certain percentage of growth) or might be established by the individual investor (for example, reach a certain retirement account value). As a goals-based target-date fund nears its benchmarks it readjusts towards more conservative investments.
The Risks of Target-Date Funds
Target-date funds are a strong option for retirement savers, but like all investment opportunities they come with several potential downsides.
It's important to understand how your target-date fund will assess risky vs. conservative assets before investing. Every fund has a different basket of investments and, while they will generally all trend towards safer products as time goes on, not every fund will do so in the same way. Some target-date funds might consider indexed mutual funds to be a safe investment, for example, buying into those while you enter your 50s and 60s. Others might accept nothing riskier than a U.S. Treasury bond at that stage in your career.
Understand how the fund assesses risk and make sure that you're on board with this.
The other side of the coin from risk assessment, make sure that you're comfortable with how the fund adjusts risks in the portfolio.
First, will the fund throttle down its speculative assets soon enough? Even if your target-date fund eventually moves entirely into AAA, guaranteed-income products, that might not do you much good if the manager keeps a basket filled with stocks and options until you turn 59.
Then, make sure that the fund doesn't throttle down too soon. You want your retirement fund secure, that's true, but you also need it to grow. Look at how the target date fund will make its early investments and decide if they're taking enough chances during the early stages of your career.
Appearance of Safety
Finally, it's easy to think that a target-date fund assures you that your money will be safe. It does not.
Funds like this are built around the idea of striking the best balance between returns and certainty, but that doesn't mean that your principal is ever guaranteed. Nor does it mean that this is a magic ticket to a safe retirement. A target date fund that over-invests in speculative assets could lose every penny you put into it, forcing you to start over again at 33. (This is the entire point of these funds, to make the riskier investments while you still have many years to recover from losses.)
Another fund might under-invest in speculative assets, keeping your money safe… but providing nowhere near enough for you to retire on when you turn 65.
Don't be lulled into a false sense of security. Make sure that you keep an eye on your target-date fund and do your best to diversify your assets. It's the only way to invest wisely.
Examples of Target-Date Funds
To see how this works in practice, let's compare two real target-date funds from the well-regarded Fidelity Freedom Index Funds.
The Fidelity Freedom Index 2030 Fund
The 2030 fund
is for people in the late stage of their careers who anticipate retiring in or around 2030. As a result we would expect it to have cycled through its aggressive stage and currently have moved into a more conservative and income-oriented phase.
Breaking down the fund, this is exactly what we find. At time of writing, nearly half of the fund (47.87%) was invested in domestic equities, chiefly in a market-indexed selection of common stocks through Fidelity's proprietary market index fund. Another 20.82% of the fund was invested in global equities through Fidelity's proprietary Global Ex U.S. Index Fund (FSGGX) focused on stock investments in major international firms such as Alibaba (BABA) and Novartis (NVS) .
Yet the fund has also begun its glide toward conservative investments. More than a quarter (27.96%) was invested in bonds, mostly through private debt and a small number of long-term Treasury Bonds. Fidelity's balance calculator indicated that this will grow until, by 2030, nearly 40% of the fund is high-value bonds.
This is a fund on its path towards income-oriented, conservative investing. Despite a preponderance of equities, it has begun shedding them in favor of investment-grade debt.
The Fidelity Freedom Index 2050 Fund
By contrast there is the 2050 fund (FIPFX) , built for people in the early mid-stage of their careers. This is a population that doesn't intend to retire for another 30 years, giving plenty of room for more risky investing. The fund reflects that.
At time of writing the 2050 fund (in contrast with its counterpart) had a full 89.11% of its value invested in stocks. Almost two-thirds of the fund (62.18%) were invested in market-indexed domestic equities, the same collection of common stocks held in the 2030 fund through Fidelity's closed market index fund. Another quarter (26.93%) were invested in global equities, once again owning shares of major international companies. This is a substantially larger investment in stock than the 2030 fund has made because the 2050 fund has far more time to recover its value if those markets take a hit.
Meanwhile, the 2050 fund held almost no debt. Only 7.5% of this fund was invested in private and government bonds at time of writing. Nor does Fidelity plan to significantly change that composition any time soon. By the firm's balance calculator, it won't begin to alter the fund composition away from risk until 2032. At this point it will begin shifting assets away from equities and toward debt to mimic the 2030 fund.
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