Target Date Fund

Target date funds (TDFs) are financial instruments designed to maximize investor returns by a specified date in the future. They carry a mixture of investments – stocks, bonds, deposits, etc. The purpose of these funds is to help investors achieve their retirement goals by providing simplified investment options.

TDFs are automated to invest in riskier instruments in the early stages and then move towards less risky securities as maturity approaches. Moreover, it ensures faster maximization of profits and then retaining these gains with slower growth. These funds are structured for investors with long-term goals. As a result, they are often used as a part of a broader investment strategy.

• A target date fund definition can be a mutual or exchange-traded fund designed to mature on a specific date and aims at maximization returns.
• These funds are prominent employer-sponsored retirement plans with automated asset allocation facilities to maximize capital appreciation from high-return investments and retain these returns to minimize losses from further riskier investments.
• The target fund glide path decides the asset allocation and the specified time horizon of each security to ensure returns optimization.
• The returns from these funds are subjected to fees and expenses associated with the fund.

Target date fund is ideal for individuals with plans or long-term goals like retirement, children's tuition, dream vacation, etc. Therefore, investors can plan and start investing in multiplying their savings. Furthermore, if the investor chooses these funds, they select an investment with a target retirement date that aligns with their retrial goals. However, the returns of target date funds can vary depending on factors, including the fund's investment strategy, asset allocation, and market conditions.

Since these funds are automated, investors do not have to worry about their money until the target date. Thus, it's a type of set-it-and-forget-it investment. Therefore, it reduces the time and effort going into short-term securities like bonds or stocks.

The main objective of TDF is to provide investors with the maximum possible returns. Therefore, they first invest in securities that give high returns, like stocks. Once the returns are amplified, these will be invested in low-risk investments. But these are low-return securities.

The goal is to help investors balance risk and returns as they move closer to retirement. Hence, it is the retention or stability phase. In addition, the target date fund glide path is designed to adjust the mix of investments in the portfolio to become more conservative over time. Therefore, investors must understand the glide path of the funds they invest in, as it can significantly impact their investment returns and retirement outcomes.

Let us understand the concept better with the help of an example.

Example #1

Suppose Jane is a young employee in an organization. Her employer sponsored a 2065 target date fund retirement plan. According to the investment structure, for the first 30 years, investments will be in stocks and mutual funds. From the 31st year, the most high-risk securities will gradually be sold to invest in low-risk bonds.

Here are the details of her portfolio:

0 – 30 years: 75% stocks, 20% mutual funds, 5% bonds

31 – 35 years: 60% stocks, 30% mutual funds, 20% bonds

36 – 40 years: 50% stocks, 20% mutual funds, 30% bonds

41 – 42 years: 20% stocks, 80% bonds

Here, the first 30 years is the growth phase, and the later 12 years is the stability phase.

Example #2

The National Bureau of Economic Research recently conducted a study that found a significant drawback of these funds. Since TDFs aim to maximize investor returns, the growth phase should generally be more extended. Therefore, the share of equities should be around 80% by the time the individual is 45 years old and should decline to 60% as the individual nears retirement.

However, most investment companies want to retain their hard-earned returns to high-risk stocks. Therefore, the share of equities falls to around 30% - 40% during retirement. Further, the research shows that investors lose approximately 1.7% to 28% of purchasing power annually. Thus, investors should study their options and weigh both sides before investing.

Let’s discuss the upside and downside of these funds.

 Pros

• These funds are excellent investment options for individuals with long-term plans. They can choose any plan depending on their target date.
• The autopilot mode is a great advantage. It doesn’t require an investor’s constant monitoring. Instead, it automatically shifts the investments according to the time horizon.
• Unlike short-term investments, individuals do not have to invest time and effort.
• Target date funds are typically diversified across a wide range of asset classes, which can help to reduce risk and volatility.

Cons

• In the growth period, investments in stocks and other high-risk securities may not yield any growth. Due to the high risk, the investor might make losses, leaving no scope for a stability period.
• High expenses and investment costs are a cause of concern in TDFs.
• These investments also need more flexibility because they cannot accommodate changing investor needs.
• Only a handful of companies offer this type of fund, and these companies also provide all the investments in the portfolio. Therefore, it makes the investor more susceptible to any issues concerning a single company.
• These funds follow the one-size-fits-all approach that does not align with the investor’s individual goal, risk tolerance, or financial situation.

A target fund is a type of fund that is designed to provide a simplified investment strategy for retirement planning. In comparison, index funds are designed to track the performance of a specific market index. And managed funds are mutual funds that professional fund managers actively manage.

This article has been a guide to what is a Target Date Fund. We compare it with index and managed funds, explain its pros and cons, and examples. You may also find some useful articles here -

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