If you’re saving for retirement through a 401(k), 403(b) or individual retirement account, you’ve likely come across both target-date funds and index funds as investment options. While both aim to grow your nest egg over the long term, they go about it quite differently. Let’s take a closer look at the key distinctions between these two fund types and the potential pros and cons of each.
What is a target-date fund?
A target-date fund is an all-in-one investment solution that automatically adjusts its asset allocation mix over time based on an anticipated retirement year. The fund starts out aggressively invested in stocks when you are younger. As you approach the target retirement year (i.e. target date), the fund automatically rebalances by gradually shifting more conservative and reducing exposure to riskier investments like stocks.
The idea behind target-date funds is to maximize growth potential earlier on through higher stock allocations, then slowly de-risk and preserve capital as retirement nears. The funds remove the need for manual portfolio rebalancing and asset allocation shifts over time. You simply choose a fund with the target year closest to when you expect to retire.
What is an index fund?
An index fund is a type of mutual fund that passively tracks a specific market index like the S&P 500. The holdings simply mirror the performance of all the stocks within that index. For example, an S&P 500 index fund owns all 500 stocks comprising that benchmark index.
Index funds keep investing costs extremely low because there is no active management required—the fund holdings simply replicate the index. Low costs mean the fund can better track its index over time. Index funds provide broad, diversified exposure to a specific segment of the market.
Target-date fund complexities
While target-date funds provide a simple, hands-off approach, they can actually be quite complex investment vehicles under the hood. Most consist of a basket of other underlying mutual funds within an overarching fund structure. Each of these underlying funds carries its own management fees that get rolled up into the overall target-date fund expense ratios.
Additionally, target-date funds make their own allocation decisions on what types of funds to hold and how to adjust those allocations annually as you approach the target retirement date. This means you’re essentially outsourcing investment decisions to the fund manager. There may also be limited transparency into what specifically you own within the overall fund structure.
Index fund cost advantages
A key advantage of index funds is their extremely low costs compared to actively managed funds like target-date funds. Instead of layered fund costs, index funds only have one inexpensive fee to track their specific benchmark index. With their simplicity and low costs, index funds have outperformed actively managed funds in many cases over long periods.
The bottom line
Both target-date and index funds can be good ways to build retirement savings through a diversified portfolio. Target-date funds offer convenience through automatic rebalancing and de-risking over time. This simple, hands-off approach appeals to many investors. However, you typically pay higher fees for that “set it and forget it” structure.
Index funds enable you to replicate diversified index performance at extremely low costs, but require you to take a bit more hands-on management of your asset allocation over time.
For investors looking for the ultimate in simplicity, a target-date fund may be suitable, assuming you’re comfortable with the higher costs and lack of transparency. Investors willing to be a bit more hands-on can potentially earn better returns by building their own portfolio of low-cost index funds across different asset classes.
As with most investing decisions, there’s no objectively “better” option between the two. The choice depends on your personal preferences, investment time horizon, comfort with investment complexity, and overall retirement strategy. Here’s our guide to finding a financial planner who won’t rip you off.
