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Save the Date: Target-Date Funds Explained

Planning to retire in 2040? There's a fund for that. Looking to retire in 2055? There is a fund for that too.

When investing in your 401(k) or other retirement plan, target-date funds might seem a relatively simple place to park your money. You pick a fund that is dated around when you plan to retire, and that fund promises to rebalance -- that is, shift the risk profile of its investments as you approach that date.

But as with any investment, target-date funds are not risk free.

What they are... and what they are not

Target-date funds are often a form of mutual fund that are designed with a timeline in mind, automatically shifting the fund's investment mix as the target date draws nearer. The closer a fund gets to its target date, the more it focuses on assets that traditionally have a lower risk profile, such as fixed income, cash, and cash equivalents. This shift across asset classes is called a "glide path."

Target-date funds are typically structured as "funds of funds," which invest in other mutual funds. They are also becoming an increasingly common choice in 401(k) plans. This is in part due to the fact that among plans that have a default investment election, 85% of plans have target-date funds set as the default, according to Deloitte.

Unsurprisingly, the amount of assets invested in these funds has surged. The 489 target-date funds tracked by Morningstar snapped up about $19.3 billion in new investments in the second quarter of this year, well ahead of the pace of new investments seen over the prior three years.

Target-date funds -- like any investment -- are not a sure thing or a guarantee.

Nearly two-thirds of investors surveyed by the U.S. Securities and Exchange Commission didn't realize that target-date funds don't provide guaranteed income in retirement. Like all investments, target-date funds can lose money if the stocks and bonds owned by the fund drop in value.

Similarly, reaching the target date doesn't mean you've saved enough to meet your retirement needs. Whether or not your retirement savings goals will be met will depend on a number of factors, including how much you contribute, the market's performance, and what other sources of retirement income you have at your disposal.

Key considerations

As with any mutual fund, fees should be a key consideration. A small percentage difference in fees can add up to a big dollar difference in the returns on your mutual fund, so it is important to be aware of all the fees associated with any fund you invest in. You can compare the fees and expenses of different funds using FINRA's Fund Analyzer.

And even though all target-date funds aim to follow a "glide path," funds with the same target dates can have rather different holdings. For instance, one may invest in more commodities while another favors international equities. It's important to take a look at the fund's prospectus to get a firm understanding of just what you are investing in.

A unique consideration for target-date funds is whether they are "to" funds or "through" funds. The former hit their most conservative mix by their target date, while the latter continue to prioritize growth even after their target date arrives, which means they hit their most conservative investment mix later than their "to" counterparts.

Moreover, once a fund gets to its most conservative mix, it usually means a high concentration in bonds, which could carry its own risks in a rising interest rate environment.

It also pays to look at your overall investments that will sit alongside your target-date funds. An outsized holding of stocks or bonds elsewhere will effectively increase your weighting in those asset classes overall, possibly either magnifying or offsetting the impact of the target-date fund holdings.

One additional wrinkle: the nature of the funds themselves is more of a "set it and forget it" mechanism by which investors put their money in and let the managers do the allocation as time goes on. However, that shift in allocation may not take into account market events or concerns. That also means it doesn't take into account changes in your broader portfolio, your situation or your risk tolerance.

No single investment approach will be one-size fits all. It's a good idea to talk to a financial professional about how a target-date fund might fit into your long-term investment strategy.

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The article Save the Date: Target-Date Funds Explained originally appeared on Fool.com.

By The Alert Investor staff. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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