Target Date Funds Take the Guesswork Out of Retirement Investing. Here’s How

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As an individual investor, it can be overwhelming to choose between individual stocks, index funds, and other investment options to build your retirement savings.

High-performing assets make the most money, and the old adage is true: higher risk can lead to higher rewards. But as you approach retirement age, you need to adjust your portfolio according to your age and have less risky assets.

That’s where target date funds come in. Target date funds are a mix of stocks and bonds in a single fund that automatically become less risky over time.

“It’s an easy way to invest with one fund that adjusts the asset allocation mix over time to minimize risk,” explains Fernanda NovaesPortfolio manager at Intercontinental wealth advisors

If your investment goal is to save for financial independence, you may want to invest without any effort on your part in a way that suits your risk tolerance, which is exactly what target date funds do.

So what are target date funds? Let’s take a look at what they are and how they work in practice.

What are Target Date Funds?

When retirement is many years away, experts recommend investing in riskier options like stocks and stocks. Then, as retirement approaches, gradually introduce less risky assets such as bonds and Treasury bills. Target date funds do this for you automatically, with no rebalancing on your part.

Pro tip

If you are choosing a target date fund, choose one that is closest to your expected retirement year. Our experts recommend broad market index funds for most young investors.

“Target date funds are what we call a fund of funds, meaning they are a mix of other funds chosen for you, such as an S&P 500 or a Russell 2000 fund. If you don’t have the time or expertise to choose, it’s better to leave it to the experts,” adds Novaes.

How do target date funds work?

When you select a target date fund, you usually select the date that best matches your expected retirement year.

“If you want to retire in 40 years, you want a target date fund for 2060. Right now it will start with more equity and equity exposure and less fixed income exposure,” says Michelle KatzenManaging Director, Certified Financial Planner and CDFA at HCR Wealth Advisors† “Over time, that fixed-income exposure is going to become a bigger part of that investment bucket, while equity gets smaller,” Katzen says.

The fund in this example would focus first on risky stocks with the potential for higher returns. As 2060 approaches, those investments will convert into lower-risk bonds that are less risky — and with lower returns. Katzen calls this the glide slope. “It’s a mandate on how your fund will be invested, so it’s very clear on day one that it’s going to get more conservative every year by reducing the equity allocation and increasing the fixed income allocation.”

Over the years, those shifting assignments may look like this:

2020: 95% equities, 5% bonds2040: 80% equities, 20% bonds2060: 40% equities, 60% bonds

The exact percentages depend on the fund you choose, but the idea is to create an automatic path to the year of your retirement.

Target Date Funds vs. Index Funds

Index funds are another investment option that offers broad exposure to the market without having to choose individual investments. But unlike target-date funds, index funds track the general market, a particular industry, or a specific stock type.

The difference is in the rebalancing.

“Index funds are not going to adjust the asset allocation for you. Whatever the fund is, it will always remain in that asset. They are not going to take into account that you will need money for your pension in 30 years’ time, like a target date fund would,” says Novaes.

If you choose a high-risk index fund, it will always carry a high level of risk and potentially a higher return.

Compare that to a target date fund that does change the level of risk. If you move away from higher risk investments in the final years before retirement, you could miss out on higher returns towards the end of the fund, but it will keep your investment safe, which is what it’s for.

Should You Invest in Target Date Funds?

The best choice for you is one that fits your investment goals, investment timeline and risk tolerance level. A good investment strategy calls for diversification – and there is no one-size-fits-all solution.

In fact, millionaire investor and founder of Personal Finance Club Jeremy Schneider says that if he could redo his entire $4.5 million investment portfolio, he would only invest in funds with a target date.

“The target-date index fund is actually the most optimal, simple, and inexpensive investment strategy,” Schneider tells NextAdvisor.

If you don’t know where to start or want to invest without thinking about your portfolio, a target date fund is an excellent choice. You can always switch to other funds whenever you want.

The important thing is to start investing – and if target date funds offer the introduction, then great.

If you decide to invest with a target date fund, the best choice is one that best matches your expected retirement year. For example, if you think you will retire around 2057, a 2060 fund makes the most sense for your timeline.

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