If you have got your eye on a retirement date, a target fund may fit the bill. When you invest for retirement, you can select a portfolio of individual securities, mutual funds, and ETFs or choose a target date fund. Its objective 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 assembles and regularly realigns a portfolio of individual mutual funds to:

  • Help manage investment risk without significantly reducing return during the fund’s growth phase
  • Try to provide continued, if sometimes modest, growth during the fund’s income-producing or asset-preservation phase

Finding a target date 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—2020, 2025, 2030, 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 traditional, though not necessarily the average, retirement age.

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Two approaches to investing in TDF

One approach to investing in a target date fund, whether it’s offered through your employer’s retirement plan or you purchase it independently, is to concentrate your retirement assets in that account rather than using it as one account among many. Because the fund is already diversified, and the manager adjusts the way it is allocated to suit the approximate number of years until you retire, you don’t have to be responsible for diversifying and reallocating a portfolio on your own.

In another approach, you might use a target date fund for a portion of your retirement portfolio while putting the rest into other investments. If you’re comfortable taking more risk than may be typical for someone your age — perhaps because your spouse has an employer pension or you have received an inheritance — you might invest a portion of your IRA in a target fund and the rest in more funds. Or, you may want to put a larger percentage into conservative investments from the start.

How do they allocate assets?

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.

Reallocation generally decreases the fund’s assets invested in equity funds, while over time increasing the assets in bond funds. The pace and style of these changes are known as the fund’s glide path and determine the allocation at the target date. This approach is based upon the 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 greater risk. Of course, bond returns aren’t guaranteed either, since bond funds are subject to credit and interest-rate risk.

Like other funds, most target date funds hold a percentage of fund assets in cash. While cash returns tend to be lower than those of equities or bonds, and may 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.

What is a fund of funds FOF?

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 non-affiliated 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 provides an overview of each fund and must be detailed enough to cover the information the Securities and Exchange Commission (SEC) requires. It’s an essential read if you’re considering a fund.

In addition, the US Department of Labor rules requires that employers who offer target date funds in a retirement savings plan provide a detailed explanation of each fund’s risks and potential return. It must cover the fund’s primary investment strategy, performance history, the risks it poses, and its fees and other expenses. In addition, you must be told what allocation the fund plans for its target date, whether that allocation will continue to change, when it will reach its most conservative point, and when the fund expects investors to start withdrawing.

You’ll want to consider these factors as you decide whether to invest in a FOF, and you’ll want to continue to monitor the fund’s progress in helping you reach your goals.

How To Invest In Target Date Funds? Detailed Guide by Inna Rosputnia

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