People can invest in target-date funds in several ways. The most common is through a company 401(k) that offers target-date funds.
A target-date fund is a type of mutual fund or ETF that is designed to help with retirement investments for anyone with a specific retirement date in mind.
Target-date funds are made up of various investments and will change over time to become more conservative as the "target date" approaches.
Target-date funds are structured in a way that's known as "fund of funds," which means they invest in numerous mutual funds instead of individual securities.
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Target-date funds, also known as life-cycle funds, are retirement funds that are designed to simplify the investment process for those who know when they plan to retire. These asset types can help investors control risk by automatically changing to more conservative assets as the "target date" — or the date at which the fundholder plans to retire — nears.
How target-date funds work
Target-date funds are structured to offer long-term investment growth over a set period of time. The name "target-date fund" refers to its target date, or the year an investor wants to meet a financial goal, which doesn't necessarily need to be related to retirement. "[Target-date funds] are used for something specific in the future, whether it's retirement or a college fund," says Fernanda Novaes, portfolio manager at Intercontinental Wealth Advisors based in San Antonio, Texas. Investors choose a fund with a target year close to their target date. While some target-date funds are invested directly in stocks and bonds, it's more common for them to be a mix of mutual funds. This mix is referred to as a "fund of funds" and is naturally diversified.
A target-date fund is designed to shift its investments automatically to reduce risk as the target date gets closer. "If you're not a savvy investor or if you don't have much time to keep looking at investments, follow the market, or understand what asset classes you should put in there, it's a simple way of putting it on autopilot," says Novaes.
Initially, the fund invests in riskier options like equity. But over time, it switches to more conservative options like bonds. Most investors would make this transition during their journey toward retirement anyway, and this fund does the work for you.
This gradual transition is called a glide path, based on the course of a landing airplane. The length and severity of the glide path depends on the fund. "There are target date funds that are five years out and there are target-date funds that are 50 years out," says Novaes. "It depends on your needs." But no matter how many years are left in a target-date fund, the glide path will be gradual.
If you need to sell a target-date fund at any time, you shouldn't have to pay exit fees. But if you invested in a taxable fund, there may be tax penalties for withdrawal.
Quick tip: Every mutual fund charges fees. Because a target-date fund is a fund of funds, your fees may be duplicated for each of the funds included in the investment portfolio. Research the total fees using FINRA's Fund Analyzer to understand the expense ratios before investing.
Example of a target-date fund
Let's say an investor is 40 years old and plans to retire at 65. So, the investor picks a Target-Date 2045 fund. The managers of the fund take care of all the behind-the-scenes work — everything from stock selection to sales to reconfiguring the balance of the overall fund.
In the early years of the fund, it is invested in more stocks than bonds because there's enough time over the next 25 years to take risks. This Target-Date 2045 fund is made up of 75% stocks. These riskier investments in the beginning could lead to better growth. If there are any downward turns along the way, there's time for the fund to recover.
Slowly over the years, the fund managers will follow a glide path. The glide path designates how frequently the managers rebalance the fund to eventually include mostly conservative assets like bonds, fixed-income securities, or cash. By 2045, the fund includes only 30% stocks without the investor having to make the decisions.
These changes that are made over time are meant to become more conservative, so that risks and losses are less likely as the target date gets nearer.
Quick tip: Look at the target-date fund's prospectus before investing. You'll be able to check factors like how the fund divides up assets over the entire lifespan, level of risk, success rate, and fees.
Pros and cons of target-date funds
There are several positives and negatives of target-date funds that are important to note before investing in one. Here are a few that investors encounter most often:
The investment process is smoother and simpler because it's designed to be the sole investment
Target-date funds are already diversified
A target-date fund is designed for investors who want to set it and forget it
The management fees may be more expensive than other retirement fundsInvestors cannot be completely hands-off because they should research different target-date funds before investing and keep an eye on performance over the yearsIt's not a customized retirement optionHow to invest in target-date funds
People can invest in target-date funds in several ways. The most common is through a company 401(k) that offers target-date funds. Some employers only offer this type of fund in their 401(k)s. Another way to buy a target-date fund is through an IRA — either traditional or Roth. All of these options are tax-advantaged. You could also buy a target-date fund from an online broker, but these may be taxable, so it's probably best to avoid that route if you can.
You can also head to a financial services company like Vanguard, Fidelity, or Charles Schwab that offers target-date funds. "Typically the easiest thing to do — let's say you have your account at Fidelity — is to pick a Fidelity target-date fund," says Novaes.
Note: According to Morningstar, management investment is an important data point to look at when choosing a target-date fund. This point shows whether fund managers have invested their personal money into the fund — and it's a reliable indicator of whether the fund will outperform its competitors.
The financial takeaway
Also, although they may seem like a straight shot toward your retirement goals, target-date funds are not without risk. Investing money in the stock market is inherently uncertain, and although they are diversified, you're not protected against losses completely. Make sure you understand the full picture of the risk before investing.
Before investing, it's helpful to check whether there's a management member with significant investments in the fund.
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