Investing for Your Life Cycle: Understanding Target-Date Funds

Shoppers of a certain age remember the days when buying peanut butter was a relatively simple affair. There were two brands, and each had a creamy and a chunky variety. Nowadays there’s an entire aisle filled with store brands, boutique brands, some “all-natural” versions, sugar free, and about six different sizes.

Choice is awesome, but too much can be overwhelming.

Some people feel the same way about investing, and that’s where target-date funds come in.

According to Keith Denerstein, the director of investment products and guidance for TD Ameritrade, a target-date fund features simplicity that can help some investors create a portfolio that meets their needs. However, he warned, not everyone benefits the same way, so it’s a good idea to consider your situation before moving forward.

What Is a Target-Date Fund?

A target-date fund, also called a life cycle fund, is a type of mutual fund made up of investments designed to help pursue goals over a certain time frame. As you progress toward your goal, the allocations in your fund change based on your expected risk tolerance. The “target date” refers to the approximate date when an investor plans to start withdrawing funds.

“Target-date funds make assumptions based on your time horizon,” said Denerstein. “You choose a fund based on when you expect to meet your goal, whether that’s retirement or sending your first child off to college.”

When you get closer to your target date, Denerstein explained, a life cycle fund will undergo changes to the portfolio’s holdings. When you’re further from your goal, the fund relies more heavily on stocks and other growth investments. As you approach the goal, your allocation changes to reflect more income investments and assets considered a lower in risk by fund managers.

But these funds aren’t for everyone, as there are pros and cons of target-date funds. Here’s a snapshot.

Pros of Target-Date Funds

Some of the potential advantages of using a life cycle fund include:

• Simplicity. A target-date fund allows investors to basically “set it and forget it” without the need to worry about complicated strategies of changing the portfolio to be more conservative as time goes on. No need for the investor to remember to tweak the portfolio.
• Broad diversification. Just as with other mutual funds and portfolio products, rather than trying to pick the “right” stock, some investors benefit from the broad-based diversification that comes with mutual funds.
• Professional asset management. Target-date funds have managers. They aren’t necessarily actively managed, but they’re subject to more management than a passive vehicle such as an index fund. Of course, some may claim this is a disadvantage, as the managers could underperform. 

Cons of Target-Date Funds

A target-date fund isn’t right for everyone. Here are some potential drawbacks to consider before moving forward:

• Assumptions are based entirely on the time horizon. A life cycle fund won’t consider your other assets, and it doesn’t know your age or personal risk tolerance.
• Not all funds take the same approach. Managers take different approaches to life cycle fund management, so it’s important to read the prospectus. The manager might not match your style and expectations.
• Fees. Although many managers use low-fee investments and funds for life cycle fund products, there are still management fees to consider. Carefully compare fees to determine what makes the most sense for you, and watch out for target-date funds that charge high management fees.

Considering Target-Date Funds?

“The key thing to understand is that if there’s a particular date in the future when you expect a goal to be accomplished, it’s worth investigating a target fund,” said Denerstein. “Retirement and college savings can be examples because you have a pretty good idea of when you’ll need the money.”

He also pointed out that many investors don’t want to go through the time and effort it takes to put together a portfolio that meets their needs. For those investors, a target-date fund might make sense. It combines simplicity with a performance that is likely to be adequate, depending on various market conditions.

However, target-date funds aren’t a cure-all, and they aren’t appropriate for everyone. It’s also important to understand that the principal value of the investment in a target-date portfolio is not guaranteed at any time, including at the target date. And remember: life doesn’t always go in a straight line. 

Think of it as you would an airplane coming in for a landing—what’s known as a “glide path”. Once it’s locked in, it only changes if there’s an emergency. And changing the glide path can be quite disruptive. Target-date funds also have a glide path, and because it’s the same portfolio mix for all investors in the fund, it’s not customizable to you. So if life forces you to change your plans, i.e., change your target date, you’d need to liquidate your fund shares and shift to other investments.

What Are Some Alternatives to Target-Date Funds?

If you aren’t sure a life cycle fund is the right choice for your circumstances, there are other ways to go about pursuing your goals.

“Managed portfolios can make sense for some investors, depending on their needs and goals,” said Denerstein. “There are different types of managed portfolios that take your preferences into account and can be tailored to more accurately reflect your financial and life situation.”

Managed portfolios are often built on preexisting strategies and can be tailored (or adjusted) a bit based on what you hope to accomplish as an investor. These managed portfolios can also be rebalanced automatically to reflect personal risk tolerance.

“Another choice, if you have the time and inclination, is to just manage your portfolio yourself,” said Denerstein. “There are different ways you can do the research and put together your own portfolio to help meet your needs.” However, it does take more time and effort. Knowledge is required, and investors need to remember to rebalance their portfolios as their goals approach.

In the end, there are plenty of strategies available to investors, depending on their interests and what fits their needs and styles.

“Think about your own needs as an investor,” said Denerstein. “Then choose products that are most likely to help fit those needs.”