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What are target date funds and why do we need them in India for retirement?

This article introduces the concept of the target date fund and explains why they are a good option for retirement planning.

What are target date funds and why do we need them in India for retirement?


Posted on 26 Feb 2023
Author: Sayan Sircar
Tags: Tags Portfolio Construction ;  Retirement ;  Asset Allocation
7 mins read

This article introduces the concept of the target date fund and explains why they are a good option for retirement planning.

What are target date funds and why do we need them in India for retirement?

Summary:
  • Target date funds (TDFs) are mutual funds designed for long-term goals like retirement and are a popular investment option in the US.
  • TDFs allow investors to invest in a single fund tagged to their desired retirement year, which starts with an aggressive allocation to the equity asset class for long-term growth and reduces equity allocation as retirement comes close.
  • The fund's asset allocation and rebalancing plan happens without investor involvement, reducing the risk of taking wrong decisions due to market movements.
  • However, TDFs do not allow customization, and implementation is important from a cost perspective.
  • The Indian market needs TDFs because most investors do not invest enough for retirement, do not invest with a plan, and have too many investment choices, leading to cluttered portfolios, lack of planning, and compounding mistakes.
  • TDFs can simplify retirement goal planning, but no asset management company offers this product in India currently.




📚 Topics covered:

What is a target date fund?

A target date fund (TDF) is a mutual fund created for a long-term goal like retirement. They are popular in the US and are not yet available in India. The premise of a TDF is to allow the investor to invest in a single fund tagged to their desired retirement year. They invest in that fund throughout their earning period and then withdraw from the same fund in retirement. TDFs are typically fund of funds, i.e., mutual funds holding other mutual funds.

This article is a part of our detailed article series on Target Date Funds. Ensure you have read the other parts here:

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How does a Target Date Fund manage its asset allocation?

Asset Allocation of Target Date Funds in the US

The fund starts with an aggressive allocation to the equity asset class for long-term growth. Then, there is a smaller bond allocation for rebalancing and stability purposes. Over time, as the retirement date comes close, the equity allocation is slowly reduced. Finally, once the retirement year is past, the asset allocation stabilizes to a small percentage of equity for growth and a larger share of bonds (and cash) for income generation.

What are the benefits of investing in a target date fund for retirement?

Simple: The main selling point of a target date fund is simplicity — one fund to invest in, nothing to track and easy to manage. For busy and non-expert investors, both young and old, TDFs work very well.

Diversified: A target date fund is well diversified between equity, debt and cash with a professionally decided asset allocation and glide path that manages risk by rebalancing and moving to a higher portion of safer assets as the retirement date approaches.

Emotion free: The fund’s asset allocation and rebalancing plan happens without the risk of overaction or inaction by the investor. Since the investor has no role in deciding how to react due to market movements, it reduces the risk of taking the wrong decisions like panic selling or not rebalancing due to inaction or fear of taxes.


Goal-based-investing plan

What are the disadvantages of a target date fund for retirement?

Customizability: A target date fund does not allow customization. At best, you can mix 2-3 TDFs to replicate a custom asset allocation to have some limited amount of control on the asset allocation and glide path.

Fund expenses: Implementation of the target date fund is important from a cost perspective. In India, mutual funds offer tax-free rebalancing inside the fund. However, it is difficult to fund such hybrid funds at lower expense ratios. Most of these funds are also active funds which make it difficult to know what will happen next with the asset allocation due to calls being made by the fund manager.

AMC risk: If you are investing in a TDF, you now have AMC concentration risk since TDF underlying funds are usually from the same AMC.

Why do we need Target Date Funds in India?

Indian investors do not invest enough for retirement

Source of funds in retirement for Indians Image © livemint.com

The chart shows that more than half of Indian households depend on their children as their retirement fund. There are many reasons for this, but one factor is complexity and an excessive number of choices, e.g. there are 10,000+ mutual funds, that make investment planning and management difficult.

Indian investors do not invest with a plan

Agewise Analysis of SIP Accounts in India Image © bqprime.com

This table shows evidence that the post-COVID-19 bull run has attracted most of the current mutual fund AuM. However, the average asset per folio is higher in the older folios, which means that the investors who have the conviction to hold into equity are the ones who have built up a substantial corpus. The average assets in the top 2 categories (4 years or above) are 3x of those in the bottom 2 (less than 2 years).

Indian investors have too many choices

There are 10,000+ mutual funds, more than 5,000 listed stocks, 50+ insurance companies, 1,000+ bonds and 2,00,000+ distributors and insurance agents in the country. If you add media to this mix, i.e. print, electronic and social leads to cluttered portfolios, a lack of planning and compounding mistakes.

Related:
12 mistakes that interrupt compounding: what to do instead

There is a potential for improvement here in retirement goal planning via simplification. Target date funds can serve this purpose. In this article, we have covered the implementation of TDFs in India using existing products since no AMC offers this product today.

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Topics you will like:

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This post titled What are target date funds and why do we need them in India for retirement? first appeared on 26 Feb 2023 at https://arthgyaan.com


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