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On Target

Mutual funds are designed to offer a group of investments that meet a stated criteria. This can be a cost efficient way to purchase a diversified portfolio. One type of mutual fund is built around a specific goal in time, like retiring. Here are some basics of how these target funds are set up.

Let’s say that you’re 47 years old and plan on retiring when you’re 65. So you decide to invest in a target fund that we’ll hypothetically name the Lifestyle 2035 Fund. This year, the fund holds about 70% of the fund in stock mutual funds, some of which hold a variety of investments in the United States and some which are abroad, and 30% in cash and bonds. These stocks and bonds are in mutual funds, so this target fund is a mutual fund of composed of mutual funds. As you get closer to retirement, the portfolio of your target mutual fund becomes more conservative, gradually moving the holdings in the fund from stocks to bonds and cash. After you retire, the fund continues to invest more conservatively. It sounds like an easy way to have a portfolio that changes as you move through your financial life.

These funds can serve a good purpose, but might not be for you, or at least not be for your entire life. A target fund can be a good choice when a young person is starting to invest in a company retirement plan for the first time. If your two major investments at that point are probably a savings account – either in a bank or a money market fund – and your company retirement plan. That doesn’t give you much money to have diversified investments, so the target fund might be a great option.

As you mature in your financial life, your company retirement plan shouldn’t be your only investment. In addition to your emergency savings and company retirement account, you ideally have other investments. That might include IRAs as well as investments that are not in retirement accounts. To be tax efficient, which accounts hold stocks and which hold interest earning investment will vary. Having a target fund as your only investment, doesn’t allow you decide where you hold stocks and where you hold bonds because they’re all in one account.

Once you retire and are ready to start withdrawing your money, the target fund does not allow you to decide whether you withdraw money from stocks or from bonds. When you withdraw money from the target fund, it takes the money proportionately from all the holdings in the fund. So a target fund doesn’t allow you to harvest gains and losses as you wish or take money only from cash and bonds during a down stock market.   

Target funds might be a good way to start your investment plan, but you’ll probably outgrow them as you build wealth.