Setting the Date


If you’ve got your eye on a retirement date, a target date fund might fit the bill.

Setting_the_date

All mutual funds have an investment objective, but none is as clear or unambiguous as the objective of a target date fund. Its reason for being is to build and then preserve assets, so that investors in the fund can look forward to a more financially secure retirement.

To meet its goal, a target date fund capitalizes on the power of asset allocation to:


FINDING A FUND

While target date funds currently make up only a small percentage of all mutual funds, they’re increasingly available in 401(k) and similar retirement plans, as an investment choice in individual retirement accounts (IRAs), and as an investment alternative in regular taxable accounts.

The financial institutions that offer target date funds never sponsor just one, but offer several funds with different end points to meet the needs of people at different stages in their lives. These end points are usually spaced in five-year or ten-year intervals — 2015, 2025, 2035, and so on, for example.

In selecting a target date fund, you typically choose a fund whose date is closest to the date you plan to retire. For most people, that’s often at some point in their 60s, since 65 remains the traditional, though not necessarily the average, retirement age.


TAKING CAREFUL AIM

There’s a right way and a wrong way to invest in a target date fund. While that is not usually true of other types of investments, the strategy for target date funds is black and white.

The right way to use a target date fund is to put all of the assets you’re investing in a 401(k), 403(b), IRA, or other retirement savings account into a single fund. The wrong way is to put some assets into the fund and spread the balance among a number of other funds with different investment objectives.

While that may contradict everything you’ve ever heard about investing, it’s the right approach because a target date fund is designed to provide the asset allocation and diversification your portfolio needs to meet your investment objective within the time frame you have set.

By putting some of your assets into additional funds, you risk throwing your overall portfolio out of balance — making it much more vulnerable to risk than you intend or too weighted down with conservative investments. Either way, you’re much less likely to maximize the benefits of a target date fund.


THE INNER WORKINGS

The time horizon of a target date fund largely determines the investments the fund owns. Over time, the balance between risk and return is adjusted, either as part of a gradual, planned reallocation or in response to a combination of changing market conditions and the passage of time, depending on the philosophy of the fund.

Rebalancing steadily decreases the fund’s assets invested in equity funds, while continually increasing the assets invested in bond funds.

This approach is based upon the well-established principle that a portfolio of equities, even if well diversified, tends to be more volatile than a portfolio of bond funds, thereby exposing you to a greater risk of losing some of your principal. (Of course, bond returns aren’t guaranteed either, since bond funds are subject to credit and interest-rate risk, but the variation from year to year tends to be less than with stocks.)

Most target date funds also hold a percentage of fund assets in cash. While cash returns tend to be lower than those of equities or bonds, and may consequently be a drag on fund results, having money on hand gives the fund managers the flexibility to make new investments without necessarily having to sell off other assets in the portfolio. The fund may also elect to keep cash on hand to buy back shares of the fund that investors wish to sell. That reserve prevents having to sell off assets to repurchase shares, potentially throwing off the current allocation.


Setting The Date

LOOKING UNDER THE HOOD

When a target date fund is a fund of funds (FOF), as most are, its underlying investments may be proprietary mutual funds offered by the investment company sponsoring the FOF, funds offered by other investment companies, or a mix of affiliated and nonaffiliated funds. Some FOFs also invest in exchange traded funds (ETFs), which share similarities with both index funds and individual equities. And some FOFs use derivative products, such as equity or index options or certain futures contracts, to hedge against risk or to leverage the fund’s assets.

The prospectus for a target date fund lists the funds that may be included in the FOF at any given time and indicates the percentages of the portfolio that will be allocated to particular asset classes at different stages. Those percentages are typically presented as a range. For example, a hypothetical 2025 fund prospectus might list 10 or 12 equity funds and indicate that 80% to 100% of the fund’s assets are invested among those funds.

When you choose a target date fund, this means you’re turning over responsibility to the fund’s managers for maintaining an appropriate allocation. But you’ll want to consider how the fund invests to meet its objectives as part of your initial selection process and your regular assessment of the fund’s progress in helping you reach your goals.