Index Funds Vs Target-Date Funds: How To Decide Which Is Right For You

The hardest part of any investment strategy is often the first step. That’s why more than a quarter of American workers today have less than $1,000 stashed in a retirement plan and a full 75% have less than $100,000—including those on the brink of retirement.

What can you do if you don’t have the time or the know-how to figure out your financial plan? Wealth-management services are too pricey for many young professionals. There also aren’t many low-cost education options available for those without a solid pool of investable assets.

To get started, many young workers turn to either index funds, which offer low-cost entry into the market, or to target-date funds, which allow a busy professional to set and forget their investment strategy. Both tactics come with advantages and disadvantages, depending on your overall goals.

Which approach is right for you?

Do you enjoy investing?

Digging into mutual fund data to uncover expense ratios while creating an overall allocation strategy is not everyone’s cup of tea.

But some people love it.

If you’re among the former, you’ll likely enjoy the process of determining an appropriate asset-allocation strategy, uncovering low-cost/high-reward investment options, and building a portfolio of index funds.

If your eyes glazed over while you read that last sentence, target-date fund investing may be for you.

The benefits of target-date funds

Target-date funds were created for good reason. There are many professionals who know they should be socking money away, but don’t have the time or inclination to make it happen.

A good target-date fund will usually do the following:

• Set a diversified asset allocation, based on age
• Rebalance assets at regular intervals to ensure assets don’t drift during volatile market conditions
• Change the overall allocation as the investor inches closer to retirement age

All of these steps take time. For those who don’t want to play an active role in an investment strategy, a target-date fund lets an investor take a set-it-and-forget-it approach.

What a target-date fund doesn’t do:

• Consider your tolerance for risk
• Allow you to modify the plan
• Monitor fees

A target-date fund can take a lot of the work out of investing, but it can’t do it all.

The cost of target-date funds

The primary argument against target-date funds is the underlying cost of the investment. Most target-date funds are simply a mutual fund made up of other mutual funds. This means the investor doesn’t have to take the time to figure out which mutual funds to buy, but it can also mean increased investment fees.

How? Each mutual fund within the target-date fund comes with an underlying fund expense. Then, many fund companies add an extra fee layer to the target-date fund itself, as a cost of choosing which funds to select within the portfolio.

I spoke with Georgia-based, fee-only certified financial planner Chris Hardy about target-date fees. Using the Fidelity Freedom 2055 Fund as an example, Hardy explained that the fund is basically a grouping of Fidelity mutual funds … with another layer of fees added on top.

“The Freedom 2055 Fund has an expense ratio of 0.75% and then the underlying funds have another layer of fees that range from 0.1 to 0.97%,” he said. “And remember that this is in addition to the overall fund fee!” Instead, suggests Hardy, many investors can receive one-on-one investment advice from a certified financial planner for less than the almost 2% cost of Fidelity’s target-date fund.

The good news is that not all target-date funds do this. The Vanguard Target Retirement Funds, for example, charge an average of 0.17%, which is the weighted average of the expense ratios of the funds within the target-date fund. The Fidelity Freedom Index Funds (different from the Fidelity Freedom Funds, listed above) are another low-cost alternative.

The bottom line: Can you hold firm during troubled markets?

Although target-date funds can be expensive, they’re not nearly as expensive as making costly mistakes in volatile markets. A target-date fund might shave off one or 2% of your assets each year, but selling your investments after, say, the market dips 4% and then missing out on its subsequent 6% gains will cost you much more.

You’ve heard the old stock market adage to buy low and sell high? Seems simple but, in the face of financial turmoil, it’s common for investors to panic, forget about a well-thought-out investment plan, and sell off a chunk of an investment portfolio—right at the market’s low point.

Interestingly, target-date fund investors are more likely to hold tight, stay the course, and not sell their investments when markets get choppy. In fact, during the market plunge of 2008, target-date fund investors were four times less likely than the holders of other investments to cash out their 401(k)s, according to T. Rowe Price portfolio manager Jerome Clark, as reported in Barron’s.

Drew Weckbach, financial planner and founder of Scaling Independence, poses the question this way: “Can you get out of your own way?” Once an investment strategy is created, he added, the most difficult part is to not touch it. If market swings are likely to pull you off course, a target-date fund can help keep you on track.

Summary

The end question is this: Is investment planning an enjoyable use of your time?

If you like sorting through expense ratio data and planning an asset allocation strategy—get in there and go crazy. If you’d rather set it and forget it, and then go do something else like play tennis or dive into a good novel, there are plenty of low-cost target-date fund options that can help you achieve your goals—without a large time commitment.

Read more:

• Best Investment Accounts For Young Investors
• 5 Mutual Funds To Get You Started