Target-date funds are mutual funds with a special twist. Image source: Getty Images.

Investors often have specific time horizons for their major financial goals, such as retirement or saving for a child's college education. Target-date funds are designed to make it easy to invest for a specific time horizon. A target-date fund is a mutual fund that invests with the assumption that investors will need to start withdrawing money from the fund at a specified point in the future. That target date defines the investment strategy that the fund uses.

Although target-date funds are typically used for retirement saving, they can be suitable for any long-term goal that calls for periodic withdrawals beginning on the target date.

How target-date funds work

Target-date funds typically use asset allocation strategies to set their risk level, but the defining feature of the target-date fund is that the fund adjusts its risk level over time. When the target date is still far away, target-date funds invest more of their total assets in higher-risk securities like stocks, with little or no exposure to more conservative investments. As the target date approaches, the fund gradually shifts its asset allocation away from stocks and other risky assets in favor of bonds and other conservative, income-producing investments.

When the target date arrives, different target-date funds use different strategies. Some funds remain invested in a mix of assets, with the assumption that those using target-date funds for retirement purposes will still need to get a combination of growth and income from their investment portfolios to ensure a healthy financial picture throughout their retired years. Other funds invest almost exclusively in principal-preserving investments like bonds and cash vehicles, assuming that investors will need their money back almost immediately and not want to take on any market risk.

Why target-date funds got controversial

The differences in the ways that different fund managers set up their target-date fund strategies raised controversy during the financial crisis and market meltdown in 2008. Some retirement investors incorrectly assumed that if they had picked a target date that had already passed or was in the near future, they wouldn't have any exposure to the plunging stock market. Those fund managers who chose more aggressive strategies caused their shareholders to suffer unexpected losses, and although the risk was evident from a reading of the fund prospectus, many investors never got the message.

As a result, many fund companies changed their target-date funds to become less aggressive. That move backfired for some, as these funds missed out on the full extent of the stock market recovery in 2009 and beyond.

Despite the controversy, target-date funds are a useful and easy way to invest for long-term goals. It's important to know how they work and what risks are involved, but the automatic way in which target-date funds adjust their investment exposure throughout your lifetime can make investing a lot simpler.

