"I keep hearing about target-date funds. What exactly are they, how do they work and are they right for me?" —Alisa, Seattle, WA
Ask many bright, accomplished woman about "diversification" and "rebalancing" and chances are you'll still get blank stares. That’s why I am a big fan of target-date funds. While they’re by no means guaranteed to give you the best returns (and every fund is different), they eliminate the confusion of fund-picking, diversification and annual rebalancing. They are common in employer-sponsored retirement plans like 401(k)s and in 529 college savings plans because they offer simplicity. Target-date funds can seem like a lazy person’s solution to investing. We say they’re great, if you’re looking for a low-maintenance way to save for retirement.
So, what are they? Target-date funds, also known as "retirement-date funds" or "lifecycle funds," are individual investments composed of several mutual funds—typically index funds—representing different asset classes. As their name suggests, they have a target date, such as 2020 or 2040, for retirement (or in the case of 529 plans, when it's time for college).
The investment companies that manage these funds make the asset allocation decisions on behalf of investors based on the target date. The risk and return potential of target-date funds can vary from company to company. Generally speaking, though, funds with a closer target date will have more exposure to bonds versus stocks and therefore be less risky and offer lower returns than funds with a later target date.
Two of the best features of these types of funds are that they are well-diversified and are automatically rebalanced by the investment company to become more conservative as the target date gets closer. They are designed to essentially be a set-it-and-forget-it investment strategy.
Critics of target-date funds argue that they can be expensive (which can be attributed to the fact that they are actively managed) and misleading, since investors don't always realize that even if a fund has the target date they want, it still might be too risky or not risky enough based on their particular needs. Some also feel that they are not rebalanced often enough. Ask questions upfront to make sure you're comfortable with the fund manager's rebalancing and allocation strategies.
When shopping for target-date funds, make sure to seek out ones that have no upfront sales charge (a.k.a. "load") and have an annual expense ratio of under 1%. You should also stick with funds that have been around since 2007, or before, so that you can get a sense of how they perform during their best and worst years. Pay attention to the investment minimum, which can range from $100 to $2,500. Lastly, know what the asset allocation plan is for the fund post-target date.
If you want to see how some major funds have performed, check out these no-load 2040 target-date funds, which all have histories of at least five years: Fidelity Freedom 2040 Fund, T. Rowe Price Retirement 2040 Fund, Schwab Target 2040 Fund, and Vanguard Target Retirement 2040 Fund.
If you are a committed DIY-er, you can potentially save money and boost your overall return by modeling an existing target-date fund and creating a similar portfolio yourself using a blend of low-cost index funds or exchange-traded funds (ETFs). Keep in mind, though, that you will need to do your own rebalancing on a regular basis.