Planning to retire in 2040? There’s a fund for that. Looking to retire in 2055? There is a fund for that, too.
When investing in your 401(k) or other retirement savings account, target-date funds, also known as life-cycle funds, are one popular option. You pick a fund that is dated around when you plan to retire, and that fund promises to rebalance—that is, shift the risk profile of its investments—as you approach that date.
What Are Target-Date Funds?
Target-date funds are designed to help manage investment risk. You pick a fund with a target year that is closest to the year you anticipate retiring, say a "2050 Fund." The closer a fund gets to its target date, the more it focuses on assets that traditionally have a lower risk profile, such as fixed income, cash and cash equivalents. This shift across asset classes is called a “glide path.” A fund’s glide path is designed to reduce investment risk over time—but glide paths can vary considerably from fund to fund.
While target-date funds aim to reduce risk overtime, they—like any investment—are not risk free, even when the target date has reached. Target-date funds do not provide guaranteed income in retirement and can lose money if the stocks and bonds owned by the fund drop in value.
And even though funds with identical target dates may look the same, they may have very different investment strategies and asset allocations that can affect how risky they are and what they are worth at any given point in time, including when and after you retire.
How Target-Date Funds Work
Target-date funds typically are structured as a mutual fund. The particular investments a mutual fund makes are determined by its objectives, which are disclosed in the fund’s prospectus. Most target-date funds are structured as what’s called a "fund of funds," meaning that they invest in other mutual funds rather than in individual securities.
Interested investors may find that target-date funds provide an easy way to hold a diversified investment portfolio that rebalances over time to become less focused on potential growth and more focused on producing income. For example, if the target date is a long time from now, the target-date fund initially will be more heavily weighted toward stock investments—that is, more focused on growth. As the target date approaches, the investment mix becomes weighted more heavily toward fixed-income or cash equivalent investments, including bonds and Treasury securities, which aim for capital preservation and/or income.
Importantly, although stocks have historically provided a higher return than bonds and cash investments (albeit, at a higher level of risk), it is not always the case that stocks outperform bonds or that bonds are lower risk than stocks. Even though target-date funds are generally designed to become more conservative as the target date approaches, investment risk exists throughout the lifespan of the fund and is difficult to foresee.
"To" or "Through" the Target Date
A target-date fund may be designed to take you "to" or "through" retirement. Generally, a "to retirement" target-date fund will reach its most conservative asset allocation on the date of the fund’s name. After that date, the allocation of the fund typically does not change throughout retirement.
A target-date fund designed to take an investor "through retirement" continues to rebalance and generally will reach its most conservative asset allocation after the target date. While these funds continue to decrease exposure to equities throughout retirement, they may not reach their most conservative point until the investor is well past age 65.
Upon reaching their target dates, some target-date funds merge into different funds that typically focus on generating income. If your target-date fund is merged into another fund, read the new fund’s prospectus to determine if it is in line with your investment goals and risk tolerance.
In either case, reaching the target date does not mean you’ve saved enough to meet your goal. Whether or not your retirement savings goals will be met will depend on many factors, including how much you invest in the fund, the fund’s market performance and other sources of retirement income available to you.
As with any mutual fund, fees should be a key consideration. A small percentage difference in fees can add up to a big dollar difference in the returns on your mutual fund, so it is important to be aware of all the fees associated with any fund you invest in. You can compare the fees and expenses of different funds using FINRA’s Fund Analyzer.
It also pays to look at your overall investment portfolio. An outsized holding of stocks or bonds elsewhere will increase your weighting in those asset classes overall, possibly either magnifying or offsetting the impact of the target-date fund holdings.
One additional wrinkle: the nature of the funds themselves is more of a “set it and forget it” mechanism by which investors put their money in and let the managers do the allocation as time goes on. However, that shift in allocation might not take into account market events or other concerns. That also means it doesn’t take into account changes in your broader portfolio, your situation or your risk tolerance. It’s important to monitor the fund’s performance and assess whether its investments continue to meet your needs and risk tolerance over time.
In addition, if you hold a target-date fund outside a tax-advantaged account such as a 401(k) or IRA, be aware of the tax consequences. As with other types of funds, target-date funds generate taxable income each year—in the form of interest, dividends and capital gains distributions—for shareholders who invest in them through taxable investment accounts.
Tips for Choosing a Target-Date Fund
- Pick your target date carefully. To invest in a target-date fund, investors typically choose the fund with the name closest to the date they plan to retire. An investor who is age 30 and wishes to retire at age 65 might choose a target-date fund with a date close to 35 years in the future. Similarly, a 50-year-old investor planning to retire at age 70 might choose a fund with a date about 20 years in the future.
- Assess how much risk you are willing to take. When comparing funds with similar target dates, examine their investment strategies so that you can select the one that best matches your tolerance for risk. Keep in mind that your circumstances could change along the way, so you should monitor the fund’s performance periodically to ensure it meets your investment goals.
- Determine whether the fund will take you to or through retirement. Read the fund’s prospectus to understand what the target date actually means and to avoid being surprised by how the fund’s asset allocation changes over time.
- Monitor the glide path of your target-date fund. Review the investments of your target-date fund periodically to ensure that the investment manager has not changed the way in which the fund reallocates assets over time. If the glide path has changed, make sure you are still comfortable that the glide path is consistent with your retirement investment strategy and the overall level of risk you are taking.
- Pay attention if automatically enrolled. If your employer has automatically enrolled you in a target-date fund in its defined contribution retirement savings plan, take time to understand the fund. Depending on your circumstances, you may find that a different option in the plan might be better suited to your retirement savings needs.