- A target-date fund is a type of mutual fund or ETF for those with a specific retirement date in mind.
- Target-date funds change over time to become more conservative as the target date nears.
- These funds are structured so they invest in numerous mutual funds instead of individual securities.
The average retirement investor’s needs are pretty straightforward: At some point in the future, they’ll need to tap into their savings to use as income in retirement.
Early on in their careers, workers are generally advised to put their retirement savings into investments that typically have higher yields, but tend to be riskier. As they get closer to retirement, they’ll move their money into safer investments with lower yields, so they don’t risk losing money right before they need it.
Target-date funds are a type of investment that does this work for you, so you don’t have to worry about protecting your assets as you approach retirement.
What are target-date funds?
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.
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:
How 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.
The bottom line
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.