(Investopedia) - Target-Date Funds vs. S&P 500 Indexing: An Overview.
Target-date funds are a popular choice for 401(k) retirement plans. The appeal is clear: The mix of investments in the fund is tailored to the current age of the investor. The fund is rebalanced over time to reflect the degree of risk appropriate at each stage of the person's career.
The convenience alone is part of the appeal. The employee doesn't have to do a thing to update the portfolio. Nevertheless, target-date funds can have certain drawbacks compared to S&P 500 Index funds.
KEY TAKEAWAYS
- Target-date funds are tailored to a specific age bracket, with the balance between risk and income gradually adjusting as the investor approaches retirement age.
- Index funds, in general, are purely mechanical constructs that duplicate a market segment.
- What sets the S&P 500 Index apart is the selection process; it tends to be slightly less volatile than the total market index fund.
*Important: The volatility of target-date funds varies from one issuer to another. The Securities & Exchange Commission notes that losses in funds with a 2010 target date ranged from 9% to 41% in 2008, at the height of the financial crisis.
Target-Date Funds
Target-date funds are tailored to the individual's retirement date. The idea is to have the mix of investments gradually change in order to maintain suitable risk levels for employees as they mature.
For example, a target-date fund may be initially designed for a person who wants to retire in 2053. If it's 2023, the investor has 30 years to go before retiring, is willing to take some risks, and has plenty of time to recover from any losses. The fund initially will be heavily slanted toward growth stocks with smaller percentages in income stocks and bonds for the sake of diversification. Over the years, the investor increasingly wants to retain and build on those early gains. By 2040, the fund has dramatically decreased its exposure to growth stocks and focuses on safer income stocks and bonds. Still later, as the time for retirement payouts approaches, the fund has all but completed the shift toward safety and contains mostly investment-quality bonds.
Pros and Cons
The advantage of this type of fund is in part convenience. The investor doesn't have to lift a finger to adjust the portfolio. The decrease in risk over time prevents an unobservant investor from losing a big chunk of money if the stock market crashes right before the retirement date.
But convenience comes with a price. Target-date funds are typically funds of funds, meaning they invest in other funds managed by the same company. In the example described above, this could mean the target-date fund, in the early days, places 60% of the money in Fund A, 30% in Fund B, and 10% in Fund C. Each of the three funds charges fees.
Moreover, the investor is paying another layer of fees for the target-date fund. If all three funds charge 0.5% per year, and the target-date fund also charges 0.5% per year, the investor ends up paying double the fees.
Another concern with target-date funds is the funds typically have 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% typically placed in bonds do not generate nearly as much return as a pure growth stock investment. With a horizon of 20 to 30 years, the opportunity cost of such inferior asset returns becomes significant.
S&P 500 Indexing
What sets the S&P 500 Index apart is the selection process. For example, a domestic total market index fund includes the big companies found in the S&P 500 but also has a number of small- and mid-cap companies, making the basket many times larger in its scope.
Unfortunately, the total market fund is fairly undiscriminating and may contain a number of holdings that are less liquid. More than 50% of the assets may be non-publicly traded, economically unviable due to ongoing losses, or otherwise unsuitable for inclusion in the index.
The S&P 500 is determined by a committee of experts at Standard & Poor's, and each asset is a viable and trackable company. Since the S&P 500 is more refined, it tends to be slightly less volatile than the total market index fund, excluding the small-cap assets, but overall performance has been very similar over the years.
Special Considerations
Index fund fees are dramatically lower than those of actively managed funds because they don't have a management team or a staff of analysts to support.
Diversification is naturally very strong since buying an S&P 500 Index fund means you are buying a stake in 500 companies. Most actively managed funds have fewer holdings, making an implosion of one stock more consequential.
The downside of an S&P 500 Index fund is it does not change substantially over time.
A young person may want to opt for riskier funds with greater potential for superior returns. Meanwhile, a person close to retirement should gradually sell S&P 500 Index fund shares and replace them with safer income-focused assets.
Do Target-Date Funds Have High Fees?
Target-date funds have higher fees than the passively managed fund choices that are typically available to employees with 401(k) plans. Annual fees for a target-date fund average 0.51% while fees for an index fund will be about 0.05%. That could be a difference of thousands of dollars over the decades during which the employee is contributing to a retirement fund.
How Do the Assets in a Target-Date Fund Change Over Time?
Broadly speaking, a fund can invest in stocks, bonds, or the catch-all "other," which could include categories like real estate and short-term "cash" assets. Within those wide categories, stocks and bonds can be growth (meaning risky) or conservative (meaning blue chip). Bonds can be aggressive (meaning lower-grade or junk) or investment-grade (safe).
A target-date fund for a young person will be heavily weighted towards stocks in general, and growth stocks in particular. This is designed to build up some early gains while the investor has plenty of time to recover from a market nosedive.
As the investor approaches retirement, the balance changes, with an emphasis on retaining those early gains while adding income-producing choices.
Is a Target-Date Fund the Same as a Robo-Advisor?
Target-date funds are designed to adjust a person's investments over time to ensure the best performance by a certain date. That date is the individual's expected retirement date.
Robo-advisors are designed to be more flexible, encouraging users to identify any financial goal and personalize a portfolio to meet it.
That said, both of these investment choices come with double fees. Robo-advisor clients pay a fee for the robo-advisor and the fees due to the investment choices (typically exchange-traded funds). Target-date funds charge fund fees for both the fund itself and the funds it contains.
The Bottom Line
Target date funds are an attractive choice for employees who want a retirement fund that automatically adjusts to reflect the life stage that they are in. They are designed to avoid the kind of disaster that can occur when a risky portfolio of volatile stocks suffers steep losses just as the 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 funds," meaning that the investor is paying an extra layer of fees. Those additional fees could make the fund's actual return compare unfavorably to other options for a retirement portfolio, such as an S&P 500 Index Fund.
By Matt Danielsson
By Cierra Murry
Fact checked by RYAN EICHLER
August 27, 2023
