Target-date funds vs. the S&P 500 index: an overview
Target date funds are a popular choice for 401(k) retirement plans. The appeal is clear: the fund’s investment mix is tailored to the investor’s current age. The fund is rebalanced over time to reflect the appropriate degree of risk at each stage of a person’s career.
Convenience alone is part of the appeal. The employee does not have to do anything to update the portfolio. However, target date funds can have certain drawbacks compared to S&P 500 index funds.
- Target-date funds are designed for a specific age group, with the balance between risk and income adjusted gradually as the investor approaches retirement age.
- Index funds, in general, are purely mechanical structures that replicate a market sector.
- What sets the S&P 500 apart is the selection process; It tends to be a little less volatile than a total market index fund.
All funds are not equal
The volatility of target date funds varies from issuer to issuer. The SEC notes that losses in funds with a target date of 2010 ranged from 9% to 41% in 2008, at the height of the financial crisis.
Target date funds
Target date funds are designed according to an individual’s retirement date. The idea is to gradually change the mix of investments in order to maintain appropriate risk levels for employees as they mature.
For example, a target date fund might be initially designed for someone who wants to retire in 2053. If it is 2023, the investor has 30 years before retirement, is willing to take some risk, and has plenty of time to recover. of any losses. Initially, the fund will lean heavily towards growth stocks with lower percentages in income stocks and bonds for diversification. Over the years, the investor will increasingly want to hold on to those early gains and build on them. By 2040, the fund will significantly reduce its exposure to growth stocks and focus on safer income stocks and bonds. Later, as the retirement payments date approached, the fund completed the transition to safety and contains mostly investment-quality bonds.
Pros and Cons
The advantage of this type of box is, in part, convenience. An investor does not have to lift a finger to adjust the portfolio. The reduced risk over time prevents the uncommitted investor from losing a large chunk of money if the stock market crashes just before the retirement date.
But convenience comes at a price. Target-date funds are usually mutual funds, which means they invest in other funds managed by the same company. In the example described above, this would mean that the target date fund, in the early days, puts 60% of the funds into fund A, 30% into fund B, and 10% into fund C. Each of the three funds charges a fee.
On top of that, the investor pays another layer of fees for the target-date fund. If all three funds charge 0.5% annually, and the target date fund also charges 0.5% annually, the investor ends up paying twice the fee.
Another concern about target date funds is that the funds usually contain a small but largely unnecessary portion of safe investments even when the target date is decades away. The argument is that the 10% to 20% that is typically put into bonds does not generate nearly as much return as investing in pure growth stocks. With a horizon of 20 to 30 years, the opportunity cost of declining asset returns is significant.
Standard & Poor’s 500 Index
What sets the S&P 500 apart is the selection process. For example, the GDP Index Fund includes the major companies in the S&P 500, but also includes a number of small and medium-sized companies, making the basket much larger in scope.
Unfortunately, the total market fund is somewhat indiscriminate and may contain a number of less liquid holdings. More than 50% of assets may not be publicly traded, economically unviable due to continuing losses, or unsuitable for inclusion in the index.
The S&P 500 is determined by a panel of experts at Standard & Poor’s, and each asset is a viable, traceable company. Since the S&P 500 is more accurate, it tends to be slightly less volatile than the total market index fund, excluding small assets, but overall performance has been very similar over the years.
Index funds’ fees are significantly lower than those of actively managed funds because they do not have a management team or staff of analysts to back them up.
Diversification is of course very powerful since buying an S&P 500 index fund means you are buying a stake in 500 companies. Most actively managed funds have less holdings, which makes the collapse of a stock all the more significant.
The downside to an S&P 500 index fund is that it does not change significantly over time.
A young person may want to choose riskier funds with a greater potential for higher returns. Meanwhile, a person nearing retirement should gradually sell shares of an S&P 500 index fund and replace them with safer, income-focused assets.
Do target date funds have high fees?
Target-date funds have higher fees than passively managed fund options that are typically available to employees with 401(k) plans. The average annual fee for a target date fund is 0.51% while that for an index fund is around 0.05%. That could be a difference of thousands of dollars over the decades that the employee contributes to the retirement fund.
How do the assets in a target date fund change over time?
Generally, a fund can invest in stocks, bonds, or an overall “other,” which can include classes such as real estate and short-term “cash” assets. Within these broad categories, stocks and bonds can be growth (meaning risky) or conservative (meaning blue chips). Bonds can be aggressive (i.e. low grade or junk) or investment grade (safe).
The Youth Target Date Fund will be heavily weighted towards stocks in general, and growth stocks in particular. This is designed to generate some early gains while the investor has plenty of time to recover from a market decline.
As the investor approaches retirement, the balance shifts, with the focus on retaining those early gains while adding income-producing options.
Is a target date fund the same as an automated advisor?
Target date funds are designed to adjust a person’s investment over time to ensure the best performance by a certain date. This date is the expected retirement date for the individual.
Robo-advisors are designed to be more flexible, encouraging users to set any financial goal and customize the portfolio to achieve it.
However, both investment options come with double the fees. Robo-advisor customers pay fees for the robo-advisor and fees for investment options (usually exchange-traded funds). Target date funds charge a fee for the fund itself and the funds it contains.
Target-date funds are an attractive option for employees who want a retirement fund that automatically adjusts to reflect the stage in life they are in. It is designed to avoid the kind of catastrophe that can occur when a risky portfolio of volatile stocks only suffers huge losses when an employee reaches retirement age.
However, keep in mind that the fees associated with target date funds can be relatively high. A target date fund is generally a “fund of the money,” which means that the investor pays an additional layer of fees. These additional fees can make the fund’s actual return compare unfavorably to other retirement portfolio options, such as the S&P 500 index fund.