How do target date funds work?

If you’re like a lot of other American workers, your workplace retirement plan includes target date funds (TDF) as a 401(k) investment option. In the 15 years that they've been around, more and more companies each year have offered TDFs to their employees. And they're not limited to employee 401(k) plans either. You can invest your IRA or other funds into TDFs, too. They're an increasingly popular investment option, especially for beginning investors. 

A target date fund is an investment fund – typically a mutual fund — that is “actively managed to a certain date.” What does that mean? It means that the fund’s manager adjusts the portfolio to a more and more conservative mix of investments as the “target date” of the fund gets closer. You, as the investor, select a target date that represents when you think you’ll want to start using the funds. Here's two examples:

• If you have your two-year-old child’s college savings in a TDF, you’d pick the fund with a target date about 15 years in the future.
• If you are 40 and are planning to retire at 65, then a TDF 25 years out might make sense for your retirement savings.

And it’s easy to know which fund has the target date you want, as the year is typically in the name of the fund.

Since TDFs are actively managed, fees tend to be a bit higher than for other mutual funds, but the “set it and forget it” nature of the funds is one reason that so many retirement savers use them. By investing in a TDF, you don't have to remember to periodically rebalance your portfolio. The fund is already balanced for you by the fund manager.

Why a diversified and balanced portfolio is key 

We’ve all likely heard the expression “don’t put all your eggs in one basket” at some point in our lives, and it’s one of the most basic pieces of advice for investors: Your money should be split up across a diversified, well-balanced portfolio of investment options to help hedge against dramatic fluctuations.  

Keep in mind, of course, that there are no guarantees a diversified investment portfolio will not lose money. But having a variety of investments – and making sure they are balanced to match your situation – spreads out your risk and can increase the odds that a loss in one category of your investment mix might be counteracted by a gain in another. 

Diversification

Diversification means that you don’t invest too heavily in any single stock or industry – and as a result, let your financial fate hinge on the performance of that one company or one market segment. Think of the Enron workers whose retirement funds were mostly invested in company stock and who lost everything when Enron collapsed. Or consider people who were primarily invested in technology stocks when the tech bubble burst in 1999-2000. 

A diversified portfolio holds stocks and other assets in a variety of companies and industries. It generally invests across these categories: 

• Large-cap ($10 billion+) companies
• Mid-cap ($2-10 billion) companies
• Small-cap ($300 million to $2 billion) companies
• Domestic companies
• Foreign companies 
• Income stocks that are expected to pay dividends in the near-term 
• Growth stocks that are expected to see longer-term increases
• Less risky, non-stock investment options like bonds
• Cash or cash equivalents 

Balanced asset allocations

Balanced means that the assets in your portfolio are allocated across an appropriate mix of investments. The percentage of the holdings in these funds typically corresponds to your age, the number of years before you need to use the money and your tolerance for risk.

If you're a young investor, for example, you might have 95% of your investments in the longer-term “growth” category of stocks. Since there are more years before you'll retire, there’s more time for you to make up any losses you experience from market ups and downs. In other words, younger people can take more risks with less chance of jeopardizing their funds in the long-term. 

If you're an investor nearing retirement, on the other hand, you might have a larger chunk in bonds, certificates or savings accounts – these instruments typically have less, if any, volatility – and a smaller proportion of their investments in stocks. Your stock portfolio may include fewer growth stocks and more income stocks. Older savers often take this more conservative stance because if they suffer a major investment setback, they don’t have as many years to make up their losses. 

Let a Target Date Fund do the rebalancing work for you

Traditional advice for retirement savings has been to rebalance your portfolio of investments on a regular basis to ensure that it’s diversified and balanced according to your age and risk tolerance. But what if you don’t know much about investing, you’re not sure what investment mix you should have, or you just don’t want to go through the hassle of rebalancing your investment portfolio every year? 

Target Date Funds can be the solution. TDFs simplify planning for investors by eliminating the need for you to rebalance your portfolio on a regular basis because the fund’s managers do all the work for you. You simply select a TDF based on when you think you’ll need to start using your money – the year you plan to retire, the year your child starts college, etc. The fund managers maintain your portfolio’s diversification and asset allocation as appropriate for people who will use their funds in that timeframe. 

Factoring in other investments 

Keep in mind that if you only move part of an existing investment portfolio (including IRAs and 401ks) to a TDF, you will still have to rebalance your remaining investments annually because your non-TDF investments might become unbalanced. So be aware that if only a portion of your investment portfolio is in a TDF and you stop rebalancing, your investments could become too conservative or too risky for your needs. 

Selecting a fund: a personal example

If your planned year for retirement falls exactly on one of the TDF offerings in your company’s retirement savings plan, it’s easy to know which fund to select. But what if you’re like me and your retirement year falls smack dab in the middle of two TDF funds in your company’s fund list? In that case, you'll want to take into account all the other assets and investments in your retirement portfolio. 

For example, my 401(k) offers 2030 and 2035 TDFs, but my retirement goal year is 2032. In choosing between the 2030 and 2035 funds, I considered several options: put 50% of my contributions into each fund, put all of my contributions into the 2030 fund or put all of my contributions into the 2035 fund. Ultimately, I decided to put 100% of my contributions into the slightly more stock-weighted 2035 fund. Why? The retirement savings I have outside my 401(k) include some rather conservative investments, so I felt that the more aggressive option was appropriate for me. And because I have some of my retirement savings outside the TDF, I will continue to periodically rebalance my retirement investments.