Overview
Target-date funds (also called target-based funds or life-cycle funds) are investment vehicles structured with the understanding that an investor’s risk tolerance typically declines as they age. These funds are specially designed to adjust their asset mix, balancing high-risk and low-risk securities to meet the investor’s retirement or other life milestones.
Key Characteristics
Target-date funds have two primary characteristics that set them apart from other types of mutual funds:
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Target Date: This is the future date set by the investor to achieve a specific goal, commonly the date of retirement. The fund is designed to evolve its allocation strategy as this date approaches.
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Glide Path: A glide path refers to the trajectory of changes in the fund’s asset allocation over time. Initially, the fund focuses on growth by allocating more to equities (high-risk assets). As the target date gets closer, the fund incrementally shifts towards more conservative investments like bonds (low-risk assets).
Example
To better illustrate how target-date funds work, consider the following example:
Angela’s Retirement Plan
Angela plans to retire in 2030. In 2020, she purchases a 2030 target-date fund. At the initial purchase, the asset allocation looks like this:
- 2020: 70% Equity, 30% Fixed Income
As time progresses, the fund manager automatically adjusts this allocation each year towards a more conservative portfolio. By the target date (2030), the allocation is expected to be:
- 2030: 20% Equity, 80% Fixed Income
Her fund’s glide path can be represented as follows:
graph LR
A[2020: 70% Equity, 30% Fixed Income] --> B[2030: 20% Equity, 80% Fixed Income]
Thus, Angela benefits from potential high returns early in the investment and lower risk as she approaches retirement.
CIFSC Classification
Target-date funds have their own category in the Canadian Investment Funds Standards Committee (CIFSC) classification system. Once these funds reach their target date, they are typically reclassified into relevant fixed-income or balanced fund categories.
Frequently Asked Questions (FAQs)
What is the main advantage of investing in a target-date fund?
The main advantage is the automatic adjustment towards a lower-risk allocation as the target date approaches, which aligns with the decreasing risk tolerance as an investor ages.
How is the glide path determined?
The glide path is pre-determined by the fund manager according to a specific asset allocation strategy designed to transition from high-risk to low-risk investments over time.
Can I redeem a target-date fund before the target date?
Yes, you can redeem your investment in a target-date fund before the target date, but it would be wise to consider market conditions and how this might affect your investment’s growth or losses.
What happens when a target-date fund reaches its target date?
Once a target-date fund reaches its target date, it typically gets reclassified under suitable fixed-income or balanced fund categories. The allocation strategy often remains conservative, ensuring risk minimization for the investor.
Glossary and Definitions
- Target Date: The specific future date when an investor aims to achieve a certain financial goal, such as retirement.
- Glide Path: The pre-determined progression of asset allocation from higher-risk investments to lower-risk investments as the target date approaches.
- Equity: Ownership interest in a company via stocks, representing high-risk, high-reward investments.
- Fixed Income: Financial investments like bonds that provide fixed periodic returns and are considered lower risk.
Key Takeaways
- Target-date funds are ideal for investors planning for specific future goals like retirement.
- Such funds reduce the need for investors to make active asset allocation decisions over time.
- They balance growth potential and risk reduction through automated allocation strategies, following a glide path towards the maturity or target date.
📚✨ Quiz Time! ✨📚
## What is a target-date fund's primary assumption about investors?
- [ ] Risk tolerance increases as investors grow older
- [x] Risk tolerance declines as investors grow older
- [ ] Investors prefer fixed-income assets at all ages
- [ ] Investors are more risk-averse in their early years
> **Explanation:** Target-date funds are based on the assumption that investors' risk tolerance decreases as they grow older, necessitating a shift from riskier assets to more conservative ones.
## What are the two main characteristics that distinguish target-date funds from other mutual funds?
- [ ] Maturity date and asset class
- [ ] Expense ratio and investor profile
- [x] Target date and glide path
- [ ] Fund manager and investment strategy
> **Explanation:** The two distinctive features of target-date funds are their target date, which aligns with the investor's life goal, and the glide path, which outlines how the asset allocation changes over time to reduce risk.
## What is meant by the 'glide path' in target-date funds?
- [ ] A fixed investment strategy
- [ ] The investor's retirement age
- [x] Changes in the fund’s asset allocation mix over time
- [ ] The performance track record of the fund
> **Explanation:** The glide path refers to the systematic adjustments in the fund’s asset allocation mix, transitioning from riskier to more conservative investments as the target date approaches.
## What is a common target date for target-date funds?
- [ ] Marriage
- [ ] Buying a house
- [ ] Children's education
- [x] Retirement
> **Explanation:** Retirement is a common target date for these funds, though other significant life events can also be used as target dates.
## How does the asset allocation of a 2030 target-date fund change from 2020 to 2030?
- [ ] 100% equity to 0% equity
- [ ] 50% equity to 50% fixed income
- [x] 70% equity, 30% fixed income to 20% equity, 80% fixed income
- [ ] 30% equity to 70% equity
> **Explanation:** As the target date approaches, the fund shifts from a higher allocation in equities (riskier assets) to a higher allocation in fixed income (safer assets), such as moving from 70% equity and 30% fixed income in the early years to 20% equity and 80% fixed income by the target date.
## Which classification do target-date funds fall under according to CIFSC?
- [ ] Equity funds
- [ ] Bond funds
- [x] Target-date funds
- [ ] Index funds
> **Explanation:** Target-date funds have their own category under the CIFSC classification, separate from equity, bond, and index funds.
## What happens to target-date funds upon their maturity date according to CIFSC classification?
- [ ] They are liquidated
- [ ] They remain in the target-date category
- [x] They are reclassified into fixed-income or balanced fund categories
- [ ] They are converted to index funds
> **Explanation:** Upon reaching their maturity date, target-date funds are moved out of the target-date group and reclassified into either fixed-income or balanced funds.
## What action is required from the fund holder to adjust the asset allocation in a target-date fund over time?
- [ ] Quarterly reviews
- [ ] Annual rebalancing
- [ ] Monthly monitoring
- [x] No action required
> **Explanation:** The fund manager automatically adjusts the asset allocation over time, so no action is required from the fund holder.
## Why might an investor choose a target-date fund?
- [ ] To manually manage their portfolio
- [x] To have a professionally managed and automatically adjusted portfolio based on their target date
- [ ] To maintain a fixed allocation of assets
- [ ] To invest only in high-risk assets
> **Explanation:** Investors might choose target-date funds for the benefit of having a professionally managed portfolio that automatically adjusts its asset allocation as the target date approaches.
## In Angela's case, what will the asset allocation be in 2030 for her target-date fund she bought in 2020?
- [ ] 70% equity and 30% fixed income
- [ ] 50% equity and 50% fixed income
- [ ] 40% equity and 60% fixed income
- [x] 20% equity and 80% fixed income
> **Explanation:** As per the example, Angela's 2030 target-date fund will transition over time to a more conservative allocation, reaching 20% equity and 80% fixed income by 2030.