Are you going to retire in 2015? 2035? 2050? There’s a target date fund with your number on it. Target date funds are designed for retirement – that’s what the “target date” is all about. Are these funds, which change their holdings over time to reflect how close you are to retiring, a good idea? There’s a bit of controversy around this question. Let’s see what they’re all about.

How Do Target Date Funds Work?

A target date fund is a “fund of funds” – meaning it’s a fund that invests in other funds. That’s unusual, and here’s why:

A typical mutual fund will buy and sell shares of specific companies like IBM or GE or Microsoft, according to the fund’s investment strategy. A “fund of funds” manager buys and sells other funds, not individual stocks or bonds.

This approach works for target date fund managers because they’re changing their holdings in different asset classes. They’ll move from riskier areas like emerging markets to safer areas like investment grade bonds. Their goal is to make sure that the level of risk is appropriate, based on the number of years remaining until retirement. A 2015 target date fund will have more bonds and high-dividend stocks than a 2050 fund.

Target Date Funds are a One-Stop Shop

The tag line of a target date fund is something like: We take care of retirement planning so you don’t have to. The draw of a target date fund is that it allocates your assets and rebalances regularly. Target date funds have become popular, especially in 401(k) plans. Plan managers like them for the same reason some investors do – they require less management and upkeep.

Risks of Target Date Funds

Of course, there are some important risks you should consider. One of the risks is that the funds are a one-size-fits-all offering that may not be well aligned with your own goals and risk tolerance. The funds assume that anyone retiring in Year X has the same investor profile. Some funds offer a minor variations for a given target year – e.g. more growth-oriented and more defensive – but they are still not customized.

A larger concern is whether the fund’s allocation methods are prudent. There was a loud outcry after the market crash in 2008 when target funds with dates between 2000 – 2010 – which should have been conservatively allocated – lost an average 22.5 percent, according to Morningstar. By handing over the decision-making process to someone else, you’re exposed to whatever flaws the manager might make.

A third concern is that target funds are vulnerable to conflicts of interest. These funds often hold other funds from their own fund family. That means you have the potential for suboptimal performance. A poorly-performing large cap value fund. for example, might get chosen ahead of more attractive choices simply because it’s part of the fund family. In addition, you’re exposed to business risk associated with that organization.

As always, read the documents carefully before you decide if this approach is right for you. Think about whether the convenience of one-stop shopping is worth the additional risks.

Have you invested in target date funds? Tell us what you think.

Get customized advice about the asset allocation that best fits your retirement goals at Jemstep.com .