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Everything you need to know about target-date funds

  • It's important to be aware of the benefits and drawbacks of target-date funds before investing.
  • On the plus side, target-date funds simplify investing with a hands-off, unemotional approach to allocation.
  • Minuses include a lack of customization and an overwhelming number of fund options.
  • Do some research on the investment company, expense ratios and how the target-date fund is rebalanced throughout the years.
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When considering target-date funds, it's important to be aware of the benefits and drawbacks — as well as whether you are the kind of person who should be investing in them. While some people love these so-called set-it-and-forget-it funds, others dislike them because of the completely hands-off approach to investing they offer.

A variety of factors contribute to determining if you should invest in target-date funds, but it is most important to first understand what a target-date fund is and how it works.

Target-date funds explained

Target-date funds are also known as life-cycle funds. They're often mutual funds that hold a mix of stocks, bonds and other investments. Their aggressiveness is determined by the timeframe selected by the investor. As their name suggests, target-date funds are designed to be long-term investments for certain future target retirement dates

How to choose a target-date fund

The name of the fund often refers to the approximate year an investor aims to retire. For example, someone expecting to retire in 2055 might choose a fund called "Retirement Fund 2050" or "Target 2060." You don't have to choose the exact year in which you plan to retire. Instead, you can choose based on how aggressive you want to be with your investments.

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If someone invested in the year 2000 with a target date of 2050, their initial fund would be heavily invested in stocks and much less in bonds. Over time the fund would become more conservative to reflect the target retirement date. As the target date approaches, the fund automatically rebalances away from stocks and more toward bonds.

Benefits

One of the biggest benefits of target-date funds is simplification. For some investors, having a simple investment plan without much interaction is preferable to having a plan that requires regular checkups and balancing.

Those who prefer a more hands-off approach may appreciate that target-date funds offer the ability to take a more aggressive stance in the market while they are young and have more time to weather the ups and downs of the stock market. Over time the fund is automatically rebalanced to reflect the retirement schedule of the individual. It becomes more conservative, so it will retain its value and not be subject to stocks' volatility.

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Another benefit of target-date funds is the ability to remove the emotional aspect of investing. For some, choosing stocks is an emotional choice, based on many individual factors. With a target-date fund, investing and rebalancing is done automatically, which helps remove potential irrational decision-making from the equation.

Drawbacks

One downside to target-date funds is the lack of customization. Target-date funds don't take into account an individual's life changes that may impact their ability to save or the impact that life events may have on an individual's retirement plans. For example, someone who chooses a target-date fund with a later retirement date in mind might end up retiring much sooner and may have a mix of funds that's too volatile for their new lifestyle.

"Target-date funds can be good choices for many people, but as with all other investments, they do require an upfront investment of time to determine the best strategy for you."

Another drawback is the sheer number of target-date funds from which to choose. While target-date funds are similarly designed, they offer different approaches to investing, based on your future retirement goals. Some of these approaches can differ from your expectations for retirement. Furthermore, some funds are more aggressive in the later years, with more allocation to stocks than bonds, while others get more conservative. Because of this, it is important to research the type of target-date fund before choosing to invest in it.

Who should use a target-date fund?

Although there's no specific type of person who should use target-date funds, you may want to consider them if you fall into the following categories:

  • You prefer a hands-off approach to investing.
  • You want to follow a traditional path in investing (aggressive allocation while young and conservative investing as retirement approaches).
  • You're not relying on this fund to provide you with all your future income.

Determine the best strategy for you

If you decide to invest in a target-date fund, it is important to do some research on the investment company, expense ratios and how the target-date fund is rebalanced throughout the years. Target-date funds can be good choices for many people, but as with all other investments, they do require an upfront investment of time to determine the best strategy for you.

If you keep an eye on your investments, are realistic about your future and plan on having a few different income streams in retirement, a target-date fund may be an investment you want to consider.

(Editor's Note: This article originally appeared on Investopedia.com.)

— By Michael Anthony Solari, principal at Solari Financial Planning

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