First Person: Understanding Target Date Mutual Funds

The concept of a target date mutual fund is fairly simple. Choose a target date, usually the year when you plan to retire, and the asset allocation of the fund will be adjusted to reduce its investment risk as the target date nears. Thus, the further out the target date, the more capital will be invested in equities, which, as a category, have a relatively high risk and high return and the less capital will be invested in lower-risk investments such as bonds or cash. As the target date draws closer and less investment risk becomes more appropriate, the share invested in equities will decrease.

Target date mutual funds have become very popular investment options for retirement accounts. If you are considering investing your retirement savings in a target date mutual fund, here are 7 things you need to know.

No Industry-Wide Asset Allocation Standards. There are not any industry wide asset allocation standards for target date funds. As a result, funds from different firms, but with the same target date may have very different investment mixes and, therefore, very different risk profiles.

Limited Performance History. Target date funds became quite popular after the Labor Department issued a rule in 2007 giving employers safe harbor if they make target date mutual funds the default investment for employees' 401(k) contributions and the funds subsequently lose money. As a result, many funds may have a limited performance history.

Not Buy, Hold and Ignore. On the surface, a target date fund appears to be a low maintenance investment option-put your money in the account and leave the asset allocation decisions to the pros until you retire and begin to draw down the balance. In fact, as with any investment, it is important to track the performance of the fund relative to expectations and to keep an eye on the asset allocation to be sure that it still matches your investment style and risk tolerance.

Asset Allocation May Change. The asset allocation guidelines for an individual target date fund can be changed at any time by the fund manager. Consequently, if you are not paying attention, your money may not be invested as you anticipated.

Comprehensive Retirement Vehicle. A target date fund is meant to establish an appropriate asset allocation for all of your retirement funds in order to help you achieve your retirement goals. If you have a portion of your retirement savings in a target date mutual fund and the rest in other investments, your overall asset allocation by class (equities, bonds, cash, etc.) likely will not match that of the target date fund. Consequently, your overall performance probably won't match that of the target date fund.

Target Date Versus Retirement Date. The target date that you choose for your fund will determine how risky the asset allocation is. While the target date you select may be the year you expect to retire, it doesn't have to be. If, for example, you want a less risky asset mix than for the target date when you expect to retire, you could choose a fund with a target date five or ten years before your expected retirement, which should have less equities in its investment mix.

No Guarantee. Target date funds do not guarantee results or ensure that you will have sufficient funds on your target date for a comfortable retirement.

Given the nature of target date funds, you should do your homework before making an investment in one. Read the prospectus of the fund before investing. In particular, consider your risk tolerance when evaluating initial and projected asset allocations for the fund. Also, find out what the fund's expense ratio is, since it can significantly affect your long-term returns.

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