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If you've opened up a 401(k) or 529 college savings account recently, there's a good chance your options included several target date funds. These all-in-one funds aim to manage your asset mix and risk level automatically. And in recent years, they've experienced quite a boom.
But what is a target date fund, also known as a "life cycle fund," exactly? And why have they become so popular?
How Target Date Funds Work
A target date fund is an investment option consisting of mostly stocks and bonds. But it's unique because as it nears a specific date, it gradually shifts more toward lower-risk assets, such as bonds and "cash equivalents," to help protect against market volatility. Investors typically choose a fund with a specific target date based on when they need to start making withdrawals — whether that's for retirement or when their child is ready to enter college. The idea is to provide investors with a highly diversified investment option that also helps prevent over-exposure to more volatile securities, such as stocks, when they need to tap their account and begin withdrawing.
For example, a fund tailored toward workers retiring in 2035 might start with 75% of its holdings in stocks — typically low-cost index funds — and roughly 25% in bonds because the target date is a decade or more away. However, by the time 2035 arrives, the total stock portion might be down to 50%. And a few years after the target, the percentage allocated toward equities could drop to 25%.
Target date or "life cycle" funds also rebalance your asset allocation based on the performance of the stock market. For example, take a fund whose goal is to hold 40% of U.S.-based stocks at a given moment in time. If the stock market hits an upswing, domestic stocks might suddenly comprise 50% of the basket because the underlying index is worth more. As a result, the fund would periodically adjust its holdings to bring the allocation back in line; in this case, potentially selling some stock shares and purchasing more bonds to balance things out.
Understanding Glide Paths
While most life cycle funds have similar goals — to provide an easy-to-use choice for investors — the offerings from different mutual funds are likely to differ in important ways. For instance, two funds with a 2040 target date may have a different split between stocks (both domestic and international) and bonds.
A key distinction between different funds is their glide path. A glide path is the changing mix of stocks, bonds and cash-equivalent instruments as the fund approaches, and then passes, the target date. Of key importance is the fund's asset makeup when you start making withdrawals.
Typically, a life cycle fund geared toward retirement will keep a substantial portion of its holdings in stocks for several years after the target date arrives. This is meant to provide the growth potential that many investors desire as they prepare for what could be a lengthy retirement. However, investments cannot guarantee growth or sustainment of principal value; they may lose value over time. Past performance is not an indication of future results. If the risk-reward profile of a fund at retirement or the start of college does not match your comfort level, you may want to look at other companies or manage your own investment options outside a life cycle fund.
Who Should Consider a Target Date Fund?
These financial products that allow individuals to "set it and forget it" may appeal to less experienced investors and those seeking a low-maintenance path toward investing. But to help achieve a more desirable result, it's still important to research a given target fund before proceeding.
Here are a few questions to ask yourself before signing on:
- What are the fees associated with the fund? Are they comparable to other self-directed investment options?
- What are the underlying funds in which the company invests? Are they the type of assets you want to include in your investment strategy?
- Is the fund's glide path one that meets your risk tolerance?
- Though past performance does not ensure future results, has the fund's historical return met or exceeded the benchmark for that target year?
A one-size-fits-all approach to investing might not represent the optimal choice for every investor. For example, those looking to invest in specific companies or specific asset classes may want to look elsewhere. But for those who are less confident in creating and maintaining a mixture of stocks and bonds on their own, a target date fund represents a solution that may be worth considering. Just keep in mind that the principal value of a target date fund is not guaranteed at any time, including the target date. As with all types of securities, the value of a target date fund will fluctuate with changes in market conditions. You may lose some or all of the principal amount invested.