Target date funds and index funds are two of the options available when you’re investing, but is one better than the other?
Money expert Clark Howard is a big proponent of saving for your future. But he knows that all of the options out there can be confusing.
In this article, we’ll look at the similarities and differences between target date funds and index funds. We’ll also explore why Clark says you should consider both for your retirement investments.
Target Date Funds & Index Funds: An Overview
Target date funds are mutual funds that can hold stocks, bonds and other assets. Index funds are mutual funds or exchange-traded funds (ETFs) that invest in wide swaths of the overall market. They achieve this by buying shares in many different companies.
The biggest difference between them is that when you invest in a target date fund, the investments will change over time. They generally become more conservative as you approach retirement age. Index funds, on the other hand, tend to be more static in their makeup.
How Do Target Date Funds Work?
A target date fund is a simple investment portfolio that’s typically made up of stocks, bonds, and other funds in a ratio that changes as you age. It’s a “set it and forget it” type of investment that requires no ongoing management by you.
Target date funds are identified by a specific future year in their name, such as 2040, 2045 or 2050. They’re targeted to investors who have a retirement date in mind. That date could be a few years from now or decades away.
As an example, here are some of the assets that make up the Schwab Target 2040 Index Fund:
Target date funds are more appropriate for tax-sheltered retirement accounts, while index funds make sense to hold in a standard brokerage account. We’ll get into that below.
“With target date funds you should be investing inside a traditional IRA, Roth IRA, 401(k),” Clark says. That would also include Simplified Employee Pensions (SEPs) and any other account where there are no tax implications to the mix of investments being changed over time.
He likes target date funds because they’re a way of putting your investing on “automatic pilot.”
But you’ll usually pay a little bit more to have someone manage your fund. As of this writing, the net expense ratio — what you will pay to own the investment — for the Schwab Target 2040 Index Fund is 0.08%. That’s almost three times as much as you’ll pay to invest in the Schwab Total Stock Market Index Fund, which has a net expense ratio of 0.03%. We’ll look at index funds in the next section.
If you don’t want to manage your investments hands-on, that higher fee could be worth it to invest in a target date fund.
“Most people either aren’t really interested in investing, are intimidated by it or don’t truly understand the long-term picture of how you build a portfolio,” Clark says. “That’s why target date funds have become so immensely popular — somebody for whom this isn’t their thing can let it be somebody else’s thing. What it does is build wealth for them methodically over time.”
How Do Index Funds Work?
Index funds are a collection of stocks that mimic certain stock indexes like the S&P 500, the Dow Jones Industrial Average (DJIA) or the Nasdaq.
When you buy an index fund, your money is split among the many companies that are tracked by those indexes. You are investing in multiple companies rather than just, say, buying a chunk of Apple stock.
Here are some of the stocks that make up Schwab’s Total Stock Market Index Fund.
“If somebody is investing in a standard brokerage account — not a tax-sheltered account — or if somebody really loves investing and managing their investments, then index funds are potentially a superior choice,” Clark says.
If you’re like most people who have a 401(k), Roth IRA or another tax-advantaged account, you’ll want to fund those accounts fully before you open a standard brokerage account with the money you have left to invest.
Index funds are usually managed passively, so you’ll probably pay less in fees than you would with a target date fund. Again, the net expense ratio for this fund is 0.03%, versus 0.08% for the more actively-managed target date fund we looked at above.
“Index funds are likely going to have lower expenses than you’d have in a target date fund and you can micro-select the funds that you want,” Clark says. “If you wanted to have an international index fund but also have a developing country fund, you could do that. It allows you to slice and dice. You’re in control.”
But if you choose to invest primarily in index funds rather than target date funds, it will require a little more effort on your part, he says.
“Index funds are really only appropriate if you’re going to review what you’re doing every year. You have to make the changes necessary over time,” Clark says. “You’ve got to be one of those people who will stay on top of it.”
How to Decide Between Target Date Funds & Index Funds
Deciding between basic index funds and target date funds really comes down to answering these questions:
How much do you want to be involved in managing your investments?
The idea behind target date funds is to “set it and forget it.” If you’re investing in index funds, you will probably need to rebalance your account yearly.
Are you investing in a tax-sheltered retirement account or standard brokerage account?
Again, Clark says that target date funds are best within tax-advantaged accounts, while standard brokerage accounts are the best place for index funds. Just make sure you’ve taken advantage of all of your tax-advantaged accounts before investing in a taxable account.
What is your tolerance for fees?
Because they are more actively managed, target date funds tend to have higher expense ratios than index funds.
How old are you and how soon do you hope to retire?
“For investments, age-appropriate is key,” Clark says. “With classic wealth-building, most people have both a retirement account and an investment account. As you get older, what financial people tend to recommend is that you have bond-type investments inside of your retirement account, while your investment account is overwhelmingly index funds. That’s because of the different tax treatment of bonds versus index funds.”
Where to Buy Target Date Funds & Index Funds
If you’re ready to invest in target date funds and/or index funds, you may not have to look much further than your job. Most employee retirement plans will have the option of investing in one or the other — or both.
The important thing to remember is that both of these investment types offer you ways to diversify investments, and both are great options for building your retirement nest egg.