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Life is complicated enough, so retirement planning shouldn’t have to be. Choosing a target date fund can make planning for retirement a whole lot easier.
With just one target date fund, you can check off all the essentials to smart long-term investing. This special type of mutual fund handles all asset allocation decisions, basing its mix of stocks and bonds on how many decades you have until retirement. And because a target date fund owns several different mutual funds, you get an instantly diversified portfolio.
That said, not all target date funds are the same (hint: fees!). Apply a little elbow grease to make sure you choose the fund best suited to your needs.
Target Date Funds Make Retirement Planning Easy
Everyone can invest their retirement savings in a target date fund. It’s just a matter of where you choose to do your investing.
If you have a workplace retirement plan, such as a 401(k) or 403(b), there’s most likely to be only one target date fund series from an investment manager—say, Vanguard, Fidelity, or BlackRock. Your choice is limited to picking the target date fund whose target year jibes with around when you expect to retire.
If you have an individual retirement account (IRA) at a discount brokerage, you may have the option to choose between the brokerage’s own target date fund as well as target date funds from other firms as well, though there may be an extra fees involved for the latter options.
How to Choose a Target Date Fund
The best target date funds have low annual expense ratios. If you’re just getting started with retirement investing, low-cost discount brokerages can be the best place to open an IRA. There is one more decision you need to tackle: Whether to do your retirement saving in a traditional IRA or a Roth IRA.
If you don’t have a workplace retirement plan, and want to save more than the current $6,000 limit on annual IRA contributions ($7,000 if you are at least 50) you can also invest in a target date fund in a regular taxable account as well.
How Many Years Do You Have Until You Retire?
All target date funds have a year in their title. There are target date funds running in five year increments from around 2020 to 2065. The year refers to when the fund assumes an investor will be nearing the traditional retirement age of 65 or so.
A target date fund’s asset allocation mix of stocks and bonds is tied to the date in its name. The farther off the date, the more the fund will emphasize stocks. But over time, the target date fund will adjust its mix to become more conservative; the formula guiding a fund’s changing asset allocation is called its glidepath.
The key to long-term investing is to own the right mix of stocks for their potential long-term, inflation-beating growth and some bonds to steady your portfolio when stocks hit one of their intermittent periods of falling value.
There is no absolute science to what the right asset allocation mix between stocks and bonds is, but as a general rule, the more decades until you expect to retire, the more you should emphasize stocks over bonds.
As one example, the Fidelity Freedom Index 2060 fund would be an appropriate choice for someone in their mid or late 20s today. It currently has about 90% invested in U.S. and international stocks and 10% in bonds. In 35 years—when today’s 25 year old is nearing 60—the 2060 fund’s glidepath will aim for a mix of about 60% stocks and 40% bonds and cash. Indeed, the Fidelity Freedom Index 2025 fund, which can make sense for someone nearing retirement today, currently has about 60% invested in stocks and 40% in bonds and cash.
How Well Diversified Is a Fund Option?
About 45% of the world’s total market capitalization is in companies based outside of the United States. “You want to peel back the onion of a target date fund and make sure it owns international stocks,” says David D’Eredita, founder of Rise Private Wealth Advisors in Tucson, Ariz.
You can find that basic portfolio information on a fund’s info page—do a quick web search of the name of the fund—as well as the website of where you own your 401(k) or IRA. When you click on the “portfolio” tab you should also confirm that the stock portion includes small capitalization and mid-cap stocks, not just the name-brand large caps, like Facebook and Google, that most people are familiar with.
“The market is more than large caps, and there are times when smaller-cap stocks do better,” says D’Eredita. For example, though large-cap stocks have been strong performers the past few years, from 2000 through early June 2021, a small-cap stock index tracking the performance of small companies returned nearly double the gain of the S&P 500 stock index.
Watch Out for Fees
If you are investing in an IRA or regular taxable account at an online brokerage, you have the leeway to pick among a variety of target date funds offered by different portfolio management firms.
The key when investing in target date funds is to keep your annual costs low. Every mutual fund charges an annual fee, called the expense ratio. It isn’t listed in your statement as a cost you paid but is a charge that is shaved from the performance reported for your fund.
Morningstar’s recent survey of target date funds reports that the average asset-weighted target date fund expense ratio in 2020 was 0.52%. That means if a fund had a 7% gross return (before fees), the net return after the expense ratio that investors would see is 6.48%.
Seems like small potatoes? It’s anything but. The best low-cost target date funds have expense ratios of 0.10% or so because they focus on owning index funds. Target date funds that use actively managed funds, meaning someone selects each stock or investment individually instead of simply trying to recreate an index’s performance, have higher expense ratios that can be 0.70% or more. (It’s also important to note that they generally also have the same, if not worse, performance than index funds.)
Save $6,000 a year in a target date fund for 30 years that charges 0.10% and you will have around $590,000 assuming a gross annualized return of 7%. Choose a target date fund with an 0.70% expense ratio and you will have around $530,000.
“That’s $60,000 less for retirement, just because of what looks like a small fee,” says D’Eredita. “Choosing a low-cost target date fund is so important.”
Enjoy Being on Autopilot—Until You Near Retirement
Once you choose a target date fund and set up automatic contributions (raising your contribution rate over time is also smart), sit back and relax. The portfolio management team that runs your fund will periodically rebalance the portfolio to make sure it sticks to its target glidepath mix of stocks and bonds.
As you near retirement and your focus shifts from building savings to figuring out a plan to generate reliable income to live off of in retirement, you may benefit from carefully reviewing if your target date fund’s asset allocation remains the right mix for you. For instance, if you expect your living expenses will be covered by your Social Security benefit and a pension, you may be comfortable investing more in stocks than a target date fund for a 60- or 70-year-old typically targets.