A target date fund is one of many long-term investment options. You may have the opportunity to choose a target date fund for your 401(k), or you may be interested in getting one from a separate provider. Before you invest, it’s important to understand how target date funds work and what their pros and cons are.

What Are Target Date Funds?

Target date funds are mutual funds that are designed to adjust over time as you get closer to your retirement. Each target date fund is made up of a group of other mutual funds, stocks, bonds, and other investments.

All target date funds include a calendar year in their name, which indicates your target retirement date. For example, if you plan to retire around the year 2040, your fund may be called Target Date Fund 2040. You don’t have to retire in your target year, but your target year provides an estimate of when you think you may retire.

A target date fund uses an asset allocation formula, so it adjusts based on your goals and the length of time you’ll be investing. As you get closer to your target year of retirement, your investments will become more conservative. Your fund may move away from riskier investments like holding equities and stocks and move toward safer investments like holding bonds and cash. This way, when you’re ready to retire, you can rely on your target date fund to have grown substantially.

For example, if you buy a target date fund in the year 2020 when you’re 45 and plan to retire at 65, your target date will be 2040. The fund may be comprised of 90 percent stocks and 10 percent bonds in the year 2020. In 2030, the proportion of stocks in your fund may start to gradually decline. By the time you turn 65 in 2040, your fund may be made of 50 percent stocks and 50 percent bonds. If you don’t cash in, the decline may continue until the fund is only about 30 percent stocks and 70 percent bonds.

Most 401(k) plans offer target date funds, but you can also start one with a target date fund company. Target date funds are diversified, so they can be your primary investment.

Potential Benefits

The process is simple

If you want a “one-stop shop” approach to investing, target date funds are a great option. You don’t have to individually pick each investment, which can be a stressful and time-consuming process. Instead, all you have to do is choose your fund, and the adjustments will happen automatically over time.

Target date funds are diversified

If you have a target date fund, you don’t need other investments. The target date fund will spread your money out over a variety of asset classes, which will provide all the diversification you need.

Target date funds are professionally managed

You can leave it to the experts to make adjustments to your fund as you get closer to your retirement date. The “set it and forget it” approach is especially popular with people who aren’t interested in or experienced with investing. Once you make your investment, you can trust that the fund is in good hands.

Target date funds are ideal for young or new investors

When you first begin investing, the idea of putting together a diversified portfolio on your own can be overwhelming. Target date funds are a great starting point for beginners. All you have to know is your approximate retirement year, and you don’t even have to be sure of that to have a successful target date fund.

You’ll pay low fees and low minimum investments

Compared to other mutual funds, target date funds have fairly low expense ratios. Expense ratios can range from 0.1 percent to 1.5 percent, but the average target date fund has a fee of about 0.5 percent. Minimum investment requirements can range from $500 to over $3,000, but some funds will waive the minimum amount if you make monthly deposits.

Potential Disadvantages

Target date funds make assumptions about risk tolerance

The farther your fund is from your retirement date, the riskier your investments will be. However, not everyone is willing to make risky investments. If you prefer funds that are more conservative, a target date fund may not be your best option.

One size doesn’t always fit all

The one-size-fits-all approach is a great way to simplify the process, but not everyone will want or need the same investment mix. Target date funds don’t give you much freedom over your investments, which can be stressful and frustrating.

It’s hard to compare target date funds

There are a variety of different funds on the market, but they all have different fees, asset mixes, and risk tolerance levels. It can be difficult to choose a target date fund because you can’t easily draw comparisons between your options.

Target date funds are tax-inefficient

You may face some steep capital gains taxes with your target date fund. As you get closer to your retirement date, the riskier investments will be sold off in exchange for more conservative ones. This will trigger capital gains taxes, which may be costly depending on the value of the investments sold. Most investors prefer to keep their target date funds inside their tax-deferred retirement plans to avoid this issue.

You’ll be stuck with one provider

Your target date fund will only include investments from the investment company’s funds, so you can’t pick and choose the managers for each asset class. You may be happy with how your provider handles all the investments within your fund, but it sometimes is better to spread your investments out over different providers who have different styles.

Like all investments, target date funds have their benefits and drawbacks

While they may not be the perfect option for everyone, they can be an easy, reliable way to save for retirement. If you’re considering a target date fund, you should research funds and providers carefully to choose the best options.