What is a target-date fund?

Target-date funds, also known as life-cycle funds, are a popular mutual fund type for retirement plans such as 401(k)s and IRAs. But they can also be used to save for a wide array of goals with a specific target date, such as a child’s college tuition.

How target-date funds work

Target-date funds work according to the principle of asset allocation, which says you should invest in different assets—such as stocks, bonds, cash, and alternative investments (“alts”)—according to your objectives and risk tolerance. That risk tolerance will likely differ at various stages in your life.

When you’re young and saving for a retirement that’s decades away, it makes sense to be more aggressive and take on more risk. Many individuals choose to invest heavily in stocks (and perhaps alts) and may lean toward those with more long-term growth potential.

But as retirement gets closer, it makes sense to shift a good chunk of your portfolio to assets that are historically less risky, such as bonds, certificates of deposit (CDs), and other fixed-income assets. And your stock portfolio might shift more toward dividend-paying stalwarts that can deliver consistent income.

The same dynamic works when investing for any long-term goal, such as paying for a child’s college education. That’s why some investors use target-date funds in 529 plans.

Target-date funds: An example

If you have a specific date when you want to retire, such as January 1, 2060, you might purchase a 2060 target-date fund. Most target-date funds have the target right there in the name, ending in 2040, 2045, 2050, and so on. The fund works by setting an end date and designing an investment plan that’s aggressive in the early years and risk-averse in later years.

For instance, the 2060 fund might be heavily invested in growth stocks if you bought it today. In a decade, it might include more value stocks, such as large industrial companies, and it might also shift a portion of its assets from stocks to bonds. By 2050, it might have only 25% of its assets in stocks at all. And by the time 2060 rolls around, it could be mostly U.S. Treasury bonds and cash equivalents.

At that point, the fund will either maintain its conservative, income-generating mix of investments or merge into a fund with a similarly risk-averse investment strategy.

Who are target-date funds for?

Target-date funds are popular with investors who have a long-term goal of gradual portfolio de-risking but little interest in studying, researching, and trading in the markets. Because they invest and change their allocations over time, target-date funds are designed for retirement savers who are comfortable leaving the rebalancing and risk-shifting in the hands of the fund’s investment team. Although no investment should be completely set-it-and-forget-it, target-date funds are about as close as you can get.

To buy a target-date fund, all you need is money and a sense of when you want to cash out. That could be your retirement date, the day your child starts college, or another goal in the future.

Target-date funds and fees

Many workers invest in a target-date fund through an employer-sponsored retirement plan, such as a 401(k) or 403(b) plan. The choices may be limited when it comes to the funds available in these plans.

Look closely at the fees associated with target-date funds, which can vary widely. Several factors determine fees, including whether the stock and bond segments are actively managed, or if the fund invests using indexes. Target-date funds with underlying index investments tend to charge lower fees. Also check whether the fund includes a 12b-1 fee, which can increase your costs over time.

Pros and cons of target-date funds

Pros

• Easy to use. You pick a fund based on your target date and the fund handles the rest, including rebalancing and shifting to less risky investments over time.
• Diversified by design. Most target-date funds include a mix of stocks, bonds, and sometimes alternative assets such as real estate investment trusts (REITs) or commodities to help spread out risk.
• Hands-off investing. These funds are meant for long-term goals and require little maintenance, making them ideal for individuals who prefer a set-it-and-leave-it strategy.

Cons

• Limited choices in some plans. If you’re investing through a 401(k), your employer may offer only one family of target-date funds, and it might not match your preferences.
• One-size-fits-most approach. Target-date funds assume all investors retiring in the same year have similar risk tolerance, which may not align with your personal situation.
• Fees can add up. Some target-date funds charge higher fees than individual index funds, especially if they’re actively managed or include a 12b-1 fee.

The bottom line

For those who want to invest for the future but don’t want to actively monitor their investments, target-date funds can be an ideal choice. But it’s important to have clear end goals in mind, specifically a target end date, or else the funds won’t be optimized for your objectives. Remember to look at the fees charged by the fund and choose a low-cost option, if possible, as those fees add up over the years.

References

• Save the Date: Target-Date Funds Explained | finra.org
• Investor Bulletin: Target-Date Retirement Funds | sec.gov
• [PDF] Frequently Asked Questions About Target-Date or Lifecycle Funds | ici.org