Target Date Funds: A Cool Start to Financial Freedom

Hi Reader,

Welcome to The Money Series and if you are new here, thank you for signing up. Personal Finance can feel ambiguous and overwhelming, but I am here to help simplify the journey.

I've been meaning to delve into the world of investing in this newsletter, and what better way to start than with a fascinating fund option for those starting on their investment journey? This week, let's look at Target Date Funds (TDFs). I hope you find this topic as intriguing as I did while putting it together.

Target Date Funds (TDFs), often known as age-based retirement investments, operate similarly to mutual funds or index funds. They are referred to as target date funds and named based on the year you plan to withdraw your money, typically aligning with your retirement date. For example, a 25-year-old planning to retire at 65 might choose a 2065 TDF. These funds usually come in increments of 5 years (i.e. 2040, 2045, 2050, etc,.) so you have to choose one closest to your target date. The composition of assets in the fund - stocks and bonds mainly - changes over time as the investor approaches retirement (mostly referred to as the ‘Glide Path’). Initially, TDFs have a higher allocation to equities (stocks) for growth, gradually shifting to bonds as the target date nears to reduce risk. While they are commonly used for retirement, TDFs can also be tailored for other long-term goals like saving for a child’s education or simply diversifying your investment portfolio.

Why Choose TDFs?

Simple and Convenient. TDFs are a great way to kick off investing and offer a hands-off approach to investing. If you prefer not to pick stocks and bonds by yourself and actively manage your investment, TDFs might be a fit for you as they are super simple to set up. It also allows you to set it and forget it. All you have to do is automate regular contributions to your selected TDF and let the fund managers do the rest.

Diversification. TDFs are invested in a broad range of bonds and stocks across sectors and geographies, allowing you to diversify without doing it yourself. This helps in spreading risk across asset classes and market sectors. Most funds invest in other mutual and index funds, enhancing the funds’ diversification.

Cost-Effective. Most TDFs have relatively lower expense ratios and are a cost-effective way of earning passive returns. Compared to hiring a financial advisor or self-managing your investment portfolio, I think these funds offer a relatively better risk-return profile. Because TDFs pool together the investments of many individuals, they can achieve lower costs and greater efficiency.

Professional Management and Automated Rebalancing. The funds are professionally managed by professional fund managers who regularly rebalance the fund’s assets. As the target date approaches, the fund automatically shifts from higher-risk investments (like stocks) to lower-risk investments (like bonds), reducing the need for you to manually adjust your portfolio.

Considerations When Choosing TDFs

A major consideration for these funds is that they are not tailored toward your specific situation and preferences. You also have no choice over the underlying assets that the fund invests in – no flexibility aside from investing and divesting. TDFs can sometimes become more conservative as the target year approaches. A popular solution if a fund becomes too conservative for you is to choose the year based on your risk tolerance too. Hence, if the risk is too low for you for your retirement year, just pick one with a later date (say 5-15 years later) to maintain a higher equity allocation.  

Tax Efficiency. You should maximize tax advantage accounts such as IRAs, 401k, and ISAs (as available to you) when investing in TDFs to minimize tax liabilities on capital gains and distributions.

Fund’s Composition. Understand if TDF invests in index funds or actively managed mutual funds. This is important because actively managed mutual funds may take active bets on the markets and have higher costs while index funds are passively managed and may be cheap. You should also compare the expense ratios of different funds and compare thoroughly before signing up for a fund. This information is usually publicly available in the prospectus of the fund.

DIY Option. You can replicate a TDF's investment strategy by directly investing in the underlying funds, potentially saving on fees. Remember, it's your money and investment plan, so you should be in control. Again, this information is usually publicly available.

In Conclusion…

You are probably wondering if signing up for a TDF means that you are stuck with the investment until the designated year. No, you are not. You can always withdraw your funds and invest them in a different investment at any time and without any exit costs. Similarly, if you have no control over where your retirement funds are invested, TDFs can serve as one of your investment vehicles.

Planning, saving, and investing for goals that are decades away can be overwhelming. Especially when you are just getting started with your career. Remember, your situation is unique to you, and you may not want to wait till your 60s to retire. This general advice can be customized to fit your uniqueness and situation.

Good news for Nigerian investors: TDFs are not just for those in Western countries. Recently, a Nigerian investment firm launched a TDF, marking a positive step in the local investment options.

Have you explored TDFs before? Do you think they might be suitable for you?

Act Now:

• Research TDFs offered by asset managers in your home country or preferred investment destination

Reflect on This:

• How much do you think you need to retire comfortably?

Till next week, I am rooting for you, money-ly!

Dee

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Disclaimer: This does not constitute financial advice. Please conduct your research or consult your financial advisor for important financial advice.