Target date funds: Learn its meaning, working and examples

As the name suggests, target date funds (TDFs) are designed to potentially achieve a financial goal with a specific target retirement date in mind, providing diversified exposure to stocks, bonds, and other assets for investors. While this is a popular option abroad, there are no target date funds in India at present.

They provide a simple, hands-off approach to investing for retirement by automatically adjusting the fund's asset allocation over time to become more conservative as the target date approaches.

For investors who don't have the time, interest, or expertise to manage their own evolving investment portfolio over a prolonged retirement planning horizon, TDFs can provide a set-it-and-forget-it option.

• Table of contents

• Target date fund definition
• The working of target date funds
• Risk tolerance over time
• Advantages of TDFs
• Disadvantages of TDFs
• Factors to consider
• Invest guide for target-date funds
• How much do target date funds cost?
• Who should opt for target-date funds?

Target date fund definition

A target date fund is a diversified mutual fund that automatically resets its asset allocation over time to become increasingly conservative as the target date nears. The target date, typically included in the name of the fund, is the approximate date when an investor would plan to start withdrawing money from the fund, such as at retirement.

TDFs hold a mix of stocks, bonds, and other investments suited to an investor's time horizon until the target date. When the target date is far off, TDFs emphasise a higher allocation to stocks (equities) to generate growth. As the target date approaches, the fund's asset mix progressively shifts from stocks to relatively stable fixed-income investments like bonds to preserve capital.

The working of target date funds

Target date funds provide broad diversification across asset classes along with automatic rebalancing and a shift towards a more conservative asset mix over time. Here is a closer look at how TDFs work:

• Diversified asset allocation: TDFs invest in a diversified mix of equities (stocks), fixed income (bonds), money market instruments etc. This instant diversification removes the burden of selecting multiple funds across assets. The exact allocation across equities, bonds, etc. depends on the time horizon until the target date and the fund’s investment approach.
• Higher equity allocation when target date is far: When the target date is far in the future, TDFs may allocate more to stocks for long-term growth potential and less to fixed-income investments. This is because there is more time for the investment to potentially tide over volatility and grow.
• Rebalancing: TDFs may rebalance back to the fund's target asset allocation over time as market movements shift the weights. Rebalancing maintains desired risk levels.
• Gradual shift to debt instruments: As the target date nears, the fund incrementally shifts its asset allocation toward income investments like bonds while reducing equity exposure. This aims to reduce the impact of volatility on the capital as the fund moves closer to the target date.

Read Also: Thematic Investment Funds: Meaning, Features & How To Invest

Risk tolerance over time

Target date funds align to the typical pattern of an investor's risk tolerance over their time horizon until retirement. For example, investors can select a TDF with a target date that aligns with their planned retirement timing, such as a 2050 Target Date Fund for someone aiming to retire around 2050.

Younger investors who are building a corpus for retirement have a higher risk tolerance since market swings have less impact the longer the remaining time horizon. TDFs cater to this by focusing on stocks early on for their growth potential over decades.

As an investor ages and the target date for accessing retirement savings approaches, their risk tolerance decreases. If there is erosion of capital closer to the target date, there is less time for it to potentially recover in value. TDFs automatically reduce exposure to volatile equities and increase stable income investments to align to this lower risk tolerance.

By mirroring the typical decline in an investor's risk appetite over time, TDFs avoid the need to manually adjust the asset allocation to reduce risk over the years.

Advantages of TDFs

• Simplicity: TDFs offer an easy hands-off approach to investing for retirement by automatically adjusting asset allocation over time.
• Instant diversification: TDFs provide exposure across a diverse mix of asset classes.
• Automatic rebalancing: TDFs save investors from having to periodically rebalance their portfolio back to target allocations.
• Professional management: TDF investors benefit from ongoing professional management.
• Alignment to risk tolerance: Gradual shift to conservative income investments matches the typical decline in risk tolerance as an investor ages toward their target date.

Disadvantages of TDFs

• Lack of customisation: TDFs follow standardised glide paths that may not be optimal for an individual investor's unique preferences and risk tolerance. Investors can't customise the allocations.
• Fund expenses: While less expensive than actively managed funds, TDFs do carry management fees like any fund that eat into net returns over time.
• Underperformance: TDF performance may lag behind simpler balanced funds that hold a static allocation without attempting to time shifts in asset allocation.
• Long holding period: Investors ideally should hold the TDF over decades until and after the target date to realise the full potential benefit rather than dipping in and out.

Factors to consider

• Expense ratio: Look for TDFs with low expense ratios, ideally below 0.20% per year. Lower fees maximise net returns.
• Company and managers: Opt for large, reputable TDF providers with strong records* managing index and retirement funds.
• Glide path: Compare the equity glide path the fund follows over time. Some take more or less risk at various points. Select a path aligned to your risk tolerance.
• Fund returns: Review past returns* across bull and bear markets. This can give an idea of effective management.

*Past performance may or may not be sustained in future.

Invest guide for target-date funds

• Select your target date: Choose a fund with a target date closest to your planned retirement timing, such as 2040 or 2050. Pick the date you expect to start withdrawing savings.
• Open an investment account: Open an investment account with a reputable asset management company.
• Make the investment: Buy units in your selected target date fund through your account.
• Hold until target date: Let the TDF do the work as it automatically adjusts its asset allocation.

How much do target date funds cost?

Target date funds have expense ratios like any mutual fund that represent the annual fee paid to the investment company for managing the fund. This fee is expressed as a percentage of assets under management.

When comparing TDFs, opt for ones with lower expense ratios. Paying less in fees each year will maximise your net investment returns over the long run.

Read Also: Opportunity Funds: Meaning, Benefits & How to Invest?

Who should opt for target-date funds?

Target date funds can be appropriate retirement investment vehicles for several types of investors. This includes:

• Passive investors: For hands-off investors who don't want to actively select and manage their own portfolios over decades.
• Busy professionals: TDFs allow busy professionals without time to tune their asset allocation to focus instead on their careers and families.
• Novice investors: Those newer to investing can benefit from the automatic diversification and rebalancing TDFs provide.
• Nearing retirement: Older pre-retirees can use TDFs approaching their target date for automatic adjustments to less risky investments.

Conclusion

Target date funds provide an appealing set-it-and-forget-it approach to investing for retirement by automatically adjusting their asset allocation over time. As the target date nears, TDFs shift from growth-oriented stocks to more conservative bonds and income investments to match an investor's declining risk capacity as they age. For hands-off investors, selecting a single TDF aligned to their planned retirement timeline can offer them diversification as well as risk management through one fund.

FAQs:

Are target date mutual funds good?

Target date funds can be a suitable choice for passive investors who want simple, diversified exposure that automatically adjusts to their time horizon. This saves them the need to change their portfolio and funds over time.

Do target date funds have fees?

Yes, target date funds have expense ratios like any other mutual fund that represent annual management fees.

What is the average return on target date funds?

Returns vary based on the specific fund and market conditions. Asset allocation is one of the key drivers of TDF returns over time.

What is diversification in a TDF?

Target date funds provide instant diversification by investing in multiple stocks as well as bonds, cash, and sometimes other assets. This mix helps mitigate portfolio volatility and risk compared to owning just a handful of stocks.

Can I hold onto a target-date fund after the target date?

Yes, TDFs can be held even after their target date.

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