Target Date Funds: Investing Essentials

Find out what you need to know about investing in target date funds.

Aug 7, 2014 at 9:49AM

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Workers across the nation know how important it is to invest for their financial futures, but most people prefer to avoid the challenge of becoming intimately familiar with the thousands of stocks, funds, and other available investments. In order to make investing easier, fund companies came up with products that enable investors to put their money into a single fund that automatically adjusts over time in order to help them reach their financial goals by a certain future date. These "target date funds" have become extremely popular, especially among investors aiming to save for retirement and other long-term goals. Let's look at target date funds and whether they make a suitable investment for your financial needs.

What are target date funds?

A target date fund is a mutual fund or exchange-traded fund that uses an asset allocation strategy to divide invested money among different types of investments, including stocks, bonds, cash, and other asset classes. Each target date fund is associated with a particular future date -- typically a year in the future when investors are expected to retire or otherwise start collecting income from the fund. For instance, if you're 49 years old this year and expect to retire in 2030 when you reach age 65, then a 2030 target date fund would be the natural choice.

The unique feature of these funds is that they adjust their investment exposure over time to match investors' declining tolerance for risk as the target date approaches. For target dates of 2040 or later, most target date funds currently invest quite aggressively, with large allocations to stocks and much smaller allocations to cash and bonds in their portfolios. As the target date approaches, though, target date funds gradually increase their holdings of bonds and other conservative assets, scaling back on stocks in order to mitigate the risk that a last-minute market crash could devastate shareholders' investments. Therefore, a 2015 or 2020 target date fund will have a lot fewer stocks than longer-dated funds.

Target Date Dartboard

What is the history of target date funds?

Target date funds have existed for more than 20 years, with Barclays Global Investors claiming the honor of introducing the first such plan in 1993. The fund was originally aimed at investors in 401(k) plans and other employer-sponsored retirement accounts, where the limited investment menus and the vast numbers of workers who were unfamiliar with investing made the notion of a one-stop investment option most attractive.

Since then, target date funds have become ever more popular. The advent of rules that allowed employers to enroll workers automatically in retirement-savings plans and choose target date funds as default investment options led to a surge in their use. Today, most major fund-providers have target date funds among their offerings, with Vanguard, Fidelity, and a host of other fund families among those with the most assets.

How big is the target date fund market?

As a result of their increasing popularity and use in employer-sponsored retirement accounts, target date funds have attracted huge amounts of assets. According to Ibbotson Associates, target date funds had $621 billion in assets under management at the end of 2013. That figure was up 28% compared to the previous year, and although a soaring stock market contributed to the increased portfolio value, positive flows of money into the funds also added to the rise in value.

With dozens of different fund families offering target date funds, it can be difficult to distinguish one from the other. The key thing for investors to understand is that different companies use different philosophies to govern the mix of investments they own within their target date funds at any particular time. For example, some target date funds with a focus on retirement still hold substantial allocations to stocks and other higher-risk assets all the way up to the target date, reasoning that investors still need some growth potential in order to finance what could be 30 years or more of living in retirement. By contrast, other target date funds ease investors toward an asset allocation composed almost entirely of conservative investments by the end date.

Confusion about the particular philosophy a given company's target date fund uses can cause unfortunate surprises if the market behaves badly, as happened during the bear market of 2008 and early 2009.

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Target date funds avoid forcing you to compete with trading experts. Source: Wikimedia Commons.

Why invest in target date funds?

Target date funds offer a simple way for investors who don't want to spend a lot of time looking at their investments to establish a reasonable portfolio to meet their long-term savings needs. In many cases, these plans are a relatively inexpensive way of getting diversified exposure. Providers use their existing funds to reach the desired asset allocation and often add minimal management fees, or no management fees whatsoever, to what those funds already charge.

Of course, the "autopilot" aspect of target date funds makes them less attractive to those who want a more active role in managing their long-term portfolios. Often, you can buy the same investments as the target date fund, but in different proportions and combinations. That way, you get more flexibility to tailor your exposure to those investments you think have the greatest potential for gains.

For most people, though, target date funds represent a good trade-off between potential return and the time required to learn about a given investment. While they're not perfect, target date funds are a big step forward for those who would otherwise simply leave all their investable assets in cash.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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