How to Choose Between Target Date Funds and Index Funds
If you’re saving for retirement through a 401(k), 403(b) or individual retirement account , you’ve likely encountered both target funds and index funds as investment options. While both are looking to increase their savings over the long term, they do so in very different ways. Let’s take a closer look at the key differences between these two types of funds, as well as the potential pros and cons of each.
What is a trust fund?
A target date fund is a comprehensive investment solution that automatically adjusts your asset allocation structure over time based on your expected retirement year. The fund starts investing heavily in stocks when you are younger. As you approach your target retirement year (i.e., target date), the fund automatically rebalances, gradually moving toward a more conservative approach and reducing exposure to riskier investments such as stocks.
The idea behind target date funds is to maximize early growth potential by increasing your stock allocation, then gradually reduce risk and preserve capital as you approach retirement. These funds eliminate the need to manually rebalance a portfolio and change asset allocation over time. You simply choose the fund whose target year is closest to when you plan to retire.
What is an index fund?
An index fund is a type of mutual fund that passively tracks a specific market index, such as the S&P 500. The holdings simply reflect the performance of all the stocks in that index. For example, an S&P 500 index fund owns all 500 stocks in that benchmark index.
Index funds keep investment costs extremely low because no active management is required—the fund’s assets simply replicate the index. Low costs mean the fund can better track its index over time. Index funds provide broad and diversified exposure to a specific segment of the market.
The Challenges of a Target Date Fund
While target date funds represent a simple, hands-off approach, they can actually be quite complex investment vehicles. Most are made up of a basket of other underlying mutual funds within the overall fund structure. Each of these underlying funds incurs its own management fees, which are included in the fund’s overall expense ratios at the target date.
In addition, target date funds make their own allocation decisions regarding what types of funds to hold and how to adjust those allocations annually as you approach your target retirement date. This means that you are essentially handing over investment decisions to the fund manager. There may also be limited transparency into exactly what you own in the overall fund structure.
Index Fund Value Benefits
A key advantage of index funds is their extremely low cost compared to actively managed funds such as target date funds. Instead of tiered fund costs, index funds charge only one low-cost fee for tracking their specific benchmark index. Because of their simplicity and low cost, index funds have outperformed actively managed funds over long periods of time in many cases.
Bottom line
Both target and index funds can be a good way to build retirement savings through a diversified portfolio. Target date funds provide convenience by automatically rebalancing and reducing risk over time. This simple, hands-off approach appeals to many investors. However, you typically pay a higher fee for a set-it-and-forget-it structure.
Index funds allow you to replicate the performance of a diversified index at extremely low cost, but require you to manage your asset allocation more carefully over time.
For investors looking for the ultimate in simplicity , a target date fund may be suitable, provided you’re comfortable with the higher costs and lack of transparency. Investors willing to be a little more practical can potentially make big profits by building their own portfolio of low-cost index funds across a variety of asset classes.
As with most investment decisions , there is no objectively “best” option between them. The choice depends on your personal preferences, investment time horizon, investment complexity, and overall retirement strategy. Here’s our guide to finding a financial planner who won’t scam you .