Rebalancing your retirement investments periodically is extremely important, yet many investors don't want to take the time to do it, or they don't understand how to allocate their investments in a way that will maximize their returns. Target date funds, also called life cycle funds, automate the rebalancing process for these investors. However, they're far from a perfect solution.
How target date funds work
A target date fund is a mutual fund that's intended to provide the ideal asset allocation for someone who plans to retire in a given year. For example, if you plan to retire sometime around the year 2040, you'd pick a 2040 target date fund. Because the fund knows when you intend to retire, it can choose investments that are appropriate for your time window. If you pick a target date fund with a date several decades in the future, then it will probably start out by investing heavily in stocks and other high-risk, high-reward investments. As you come closer and closer to your retirement date, the fund will gradually shift its investments away from volatile assets and toward lower-risk options.
Some target date funds invest in individual stocks and bonds, while others invest in mutual funds, making them a "fund of funds." Some are actively managed, while others choose a passive approach by copying the performance of a chosen benchmark, typically a stock or bond index.
Common misconceptions of target date funds
Target date funds are not risk-free, or even low-risk. They share the same types of risks as the investments they're composed of. For example, a target date fund made up of stocks and bonds has the same risk level as a standard mutual fund made up of those same stocks and bonds. Nor are target date funds guaranteed to get you to your savings goal by the target date; that will depend on how much you contribute, how well the fund performs, the behavior of the economy, and many other factors.
Also, not all funds follow the same investment philosophy. The rate at which target date funds switch over to more conservative investments varies widely, as do the initial and final mix of investments.
If you participate in a 401(k) plan, your employer will likely put you in a target date fund by default. Unfortunately, the descriptions of these funds tend to give investors the impression that they can just leave the fund to do its thing and come back to it in a few decades when they're ready to retire. In reality, it's important to keep an eye on your retirement investments -- whatever form they take -- to make sure they are meeting your needs. Target date funds do take some of the load off by automating investment allocations, but you still need to check on them regularly (at least once a year) to be sure that these allocations match your own risk tolerances and that the fund is providing decent returns.
Also, if you invest part of your money in a target date fund and put the rest in other investments, the combination can throw off your overall asset allocations and create a portfolio that's either too risky or too conservative. If you do choose to split your investments between target date funds and other options, be sure to check the target fund's current allocations and adjust your other investments accordingly.
Finally, as with most kinds of investments, there are good target date funds and bad target date funds. Take a look at the prospectus for your 401(k)'s target date fund to confirm that it's one of the good ones before you put your money into it. Things to watch out for include fees, allocation strategies (does the fund's strategy match your own preferences?), whether it's a "to" date or "through" date fund ("to" date funds stop reallocating on their target date, while "through" date funds continue to rebalance during your retirement years), and whether the target date correlates with your intended retirement date.
Is a target date fund right for you?
If you don't fall into the trap of picking a target date fund blindly and then ignoring it thereafter, such a fund may be a helpful tool in keeping your retirement investments properly balanced. They're particularly useful for investors who want to pick a single fund for their retirement accounts and don't like to fiddle around with their investments. Just remember to check the fund at least once a year and compare its performance to that of similar funds to make sure it's doing a good job for you.
On the other hand, if you enjoy playing around with your investment options and like to have a variety of investments, you won't get much benefit from a target date fund. 401(k)s typically offer access to only a single family of target date funds, so if you don't like your account's target date fund option you'll just have to go with another type of investment. On the other hand, IRAs offer access to many types of target date funds, which gives their account holders a lot more leeway in choosing just the right fund.