What Are Target Date Funds And How Do They Work?

When choosing your 401(k) plan, you may have noticed names of investment options like "Target 2050" or "Retirement Fund 2045." These investment vehicles, known as target date funds, are mutual funds or ETFs that shift their mix of investments to maximize the value at a specific date in the future. Target date funds are popular for retirement investing because of their asset diversity and the long-term benefits they provide without a long-term commitment of your time and attention.

Follow along below to see whether target date funds are the right vehicle to put you in the fast lane toward retirement.

How Do Target Date Funds Work?

Target date funds are typically made up of a mix of asset classes such as stocks, bonds and other securities. This asset diversification is a crucial part of the strategy to benefit from many types of high-performing investments and to reduce your risk if some do not perform well.

At the beginning of a fund's life cycle, the mix is weighted with higher-risk investments like stocks that offer the possibility of higher returns but also a higher chance of losing some of your investment. However, since these are long-term investments that you don't plan on accessing for decades, you can afford to take on this risk.

As time passes, the target date fund automatically changes the mix of investments in the fund to less risky options offering lower returns. As you approach the date that you'd like to access the money, you will want to be confident that the fund will not lose a significant amount of value, so you will probably be ok with the lower rate of return.

Professional investment managers typically make asset allocation decisions, choosing how to shift the investments throughout the fund's lifecycle. This allows you to make diversified investments for the long term without constantly managing them yourself.

Let's say you start investing in a target date fund at the beginning of your career at 22 years old. With such a long time before you need the money at retirement, your target date fund could allocate as much as 90% of your investment to stocks with higher risk and higher reward. As you grow older, the ratio of stocks in your portfolio will decrease as the ratio of less risky bonds increases. By the time you retire, you could have between 30% – 50% of your investment allocated to stocks.

Why Invest In Target Date Funds?

Target date funds are an excellent vehicle for investing for retirement, which is a big reason why they're so popular for 401(k)s. Target date funds give workers, especially young ones early in their careers, an opportunity to passively and responsibly prepare for their future. Instead of researching multiple avenues for investments and changing them constantly throughout their careers, young people investing in target date funds can make one decision and relax with the confidence that their investment is being adjusted based on their predetermined needs.

The "set-it-and-forget-it" nature of target date funds is a large part of the appeal for younger and older investors alike. As you grow in your career, have a family and a host of other responsibilities, your goals and investment risk tolerance change as well. It can be a huge relief to know that the money you invested in a target date fund is on your desired pace without requiring your thought or intervention.

There are two main reasons you can "forget it" after investing in a target date fund. First, you're investing in a wide array of stocks, bonds, and securities across the U.S. market and even the international market. This diversification ensures that if one section of the economy is underperforming, another section you invest in could make up the difference. Second, expert portfolio managers manage the details of this diversification with a financial incentive to ensure your investments increase. This expert assistance lets you sleep well at night, knowing you don't have to react personally to changing market conditions.

Understanding Types Of Target Date Funds

• "To" target date funds: a fund that reaches its most conservative mix at the target date and then stops adjusting its mix of investments. These are best for investors ready to withdraw all their funds at the target date.
• "Through" target date funds: a fund that continues adjusting its mix of investments even after the target date. These are best for investors who may want to withdraw their funds gradually after the target date, essentially as a replacement for their income.
• Target-date fund glide path: the formula that portfolio managers use to plan their asset allocation. Depending on how conservative or aggressive you'd like to be with your investments, you can choose a fund with a glide path that retains riskier investments for a more extended period or vice versa.
• Target date mutual funds: Most target date funds are mutual funds. Mutual funds are companies that investors can buy shares of to profit from the income these companies derive from investments in securities. Mutual funds comprise diversified asset classes and are typically actively managed by professional portfolio managers.
• Target date exchange-traded funds (ETFs): Some target date funds are also ETFs, which are similar to mutual funds in that they comprise diverse assets. The significant differences are that they can be traded on exchanges like stocks, while mutual funds can only be purchased at the end of the trading day. ETFs are also usually more passively managed than mutual funds.

How To Invest In A Target Date Fund

Your first encounter with a target date fund is likely while choosing your 401(k) retirement plan at your first job. Depending on your workplace's plan, you could choose from one of several large brokers, such as Vanguard, Fidelity or BlackRock. However, you don't have to have a workplace retirement plan to invest in target date funds. You can also invest with an individual retirement account (IRA) which has similar tax benefits but does not have to be sponsored by your workplace. Another option is to invest directly through an investment broker but keep in mind that you will miss out on the tax benefits of retirement accounts.

Choosing which specific target date fund is right for you largely depends on your age and when you plan to retire. Someone starting their career who wants to retire by the time they're in their mid-60s may look to invest in a fund with a target date in 2060 or 2065. Target date funds typically have maturity dates in 5-year intervals. 

The Bottom Line

Target date funds are a long-term investment vehicle that adjusts the risk factor of your investment over time. After investing in high-risk, high-reward investments early in their lifecycle, target-date funds gradually invest in more conservative securities to maximize returns by a specific end date. They are made up of a mix of stocks, bonds and other securities to offer a diversified asset portfolio to investors.

The asset allocation in a target date fund is typically decided by portfolio managers that choose the investments based on a formula known as the glide path. If you want to invest in a target date fund, research the plans offered by your 401(k) provider, your IRA, or an investment broker. If you're looking for other ways to automate your investments and budgeting, sign up for Rocket Money^SM today.