The Hows and Whys of a Target Retirement Fund

You’ve finally decided that you need to start saving for retirement. You’ve taken that first step of signing up for a 401(k) or a 403(b) or a Roth IRA.

The next step is a doozy, tough. You see tons and tons of investment options. How do you know which one to choose?

You turn to guides for retirement and see lots of advice. Many suggest a Target Retirement Fund. Why? What’s so good about a Target Retirement Fund?

That’s what I hope to explain today. I personally use a Target Retirement Fund for much of my retirement savings, as everything in my retirement plans is in a Target Retirement Fund or something similar. I believe they’re incredibly valuable tools for retirement planning.

The Basics of Retirement Savings

To understand what a Target Retirement Fund is, you first need to understand a few basic things about what it means to save for retirement. The big thing to know is that the further you are from retirement, the more risk you can take with your retirement savings, and the closer you are to retirement, the less risk you can take.

Most investments can be judged on three things: liquidity, risk, and return.

Liquidity means how easy it is to take money in and out of that investment, so something like a savings account is considered more “liquid” than, say, a fully mortgaged house. Most of the time, this is a non-issue in retirement savings because most investments are in the form of mutual funds, which are usually quite liquid.

Risk refers to the possibility of a bad outcome; in this case, it’s the possibility of losing money in an investment. For many investments, there is some risk that over a given period of time, the value of that investment will go down.

Return refers to the amount of money you expect to earn on that investment, usually given historical trends.

An example will make this clear. Over a long period of time, you can expect a 7% annual return on a broad stock market investment, like an index fund that owns all stocks in the United States. However, there is some risk – if you withdraw that money at any given point, you might not get that 7% annual return. It might be less – in fact, it might be that you get no return at all. Over a long period of time, though, the average will end up being somewhere close to 7% per year.

So, if you’re 30 years from retirement, you can probably expect a 7% annual average on your stock investments between now and retirement. When you’re only 5 years out, though, the returns become more volatile. You might see a loss over those five years, for example.

That’s why it makes sense for people, as they get closer to retirement, to start slowly moving their money into something with a lower average annual return but with more stability. That way, you’re not facing the possibility of a huge dip in your retirement savings just as you’re about to retire.

So, at the 30 year mark, you might want almost all of your retirement savings to be in the stock market, for example, but at the 5 year mark, you’ll probably want a significant chunk of your retirement savings to be in safer things like highly-rated bonds and even in cash. That way, you won’t see a major fall in your retirement savings just before you actually retire.

Of course, taking care of this yourself can be a chore. You have to remember to regularly visit your retirement savings – preferably each year – and move a little bit out of stocks and into something safer. You’re going to have to assess a number of investments in order to do this in an intelligent way. That’s a lot of work.

What Is a Target Retirement Fund?

That’s where a Target Retirement Fund steps in. A Target Retirement Fund does this rebalancing for you.

Each Target Retirement Fund that you see comes with a year associated with it, like Target Retirement 2030 or Target Retirement 2045. Within that fund, investments are balanced under the assumption that you’re retiring in that target year.

For example, if you look at Vanguard’s Target Retirement 2045 fund, you’ll see that it’s currently 90% stocks and 10% bonds. On the other hand, if you look at Vanguard’s Target Retirement 2020 fund, it’s about 60% stocks and 40% bonds, and Target Retirement 2010 is about 40% stocks and 60% bonds.

Each year, these funds will gradually adjust toward owning fewer stocks and more bonds. The ones that are far from maturity will do this very slowly, but ones that are closer to maturity – or even past it – will do it faster.

The idea behind them is that you’ll just put all of your retirement savings into a single Target Retirement Fund, chosen based on when you expect to retire, and then leave that money there for the rest of your life, letting the people who run the fund do all of the balancing for you.

In other words, Target Retirement Funds offer an easy “one stop shop” for retirement savings that are automatically geared for growth when you’re younger but shift to security when you’re older.

What Are the Drawbacks?

The biggest drawback is that Target Retirement Funds offer a one-size-fits-all approach. Some people are willing to take on more risk than others. Some people want to take on less risk than the average.

If you feel that a Target Retirement Fund isn’t aggressive or conservative enough for you, you can always split your contributions up. Contribute most of your money to a Target Retirement Fund, but put some of it in another very aggressive or very conservative investment to balance things out the way you like.

Another drawback is that some of the individual elements of a Target Retirement Fund might not be all that great. Since a Target fund is made up of a collection of investments, some of those investments might not be great examples of that particular type of investment. For example, you might find that a Target Retirement 2045 fund has its money in a stock investment that doesn’t perform all that well.

The option here is to just balance things yourself. You can just log in each year and rebalance your retirement savings to match whatever Target Retirement Fund you want, except that you’re choosing what you consider to be the “best” comparable investments. For many people, the benefits of doing this won’t add up to make it worth the effort or the potential of having too much risk due to not rebalancing often enough.

What I’m Doing

Personally, I have all of my retirement savings in Target Retirement funds. I don’t see enough of a benefit to have separate investments at that point. My Roth IRA is through Vanguard and all of it is invested in their Target Retirement 2045 fund (as I’m approximately 30 years from “retirement”). I have been happy with the performance and investment ease so far.

If you’re uncertain about what to do in terms of retirement investing, my suggestion is to get started on retirement savings now and just use the appropriate Target Retirement Fund available to you. Continue to learn more and if you feel that you’re better off managing it yourself, move that money to different investments within your retirement account. My guess is that you’ll find the quality and convenience of a Target Retirement fund to be a great choice for you.

Trent Hamm

Founder & Columnist

Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.