401(k) investing can be a stressful and mentally exhausting practice, so it is only natural for participants to look for a simple solution. Thus, target-date fund entered the picture in 1994 and have become popular 401(k) investing vehicles. Before you allocate all of your retirement contributions, take a step back and ask yourself a few questions. Are they a good fit for you and your personal situation? What are they designed to do? To help you decide, here are a few things to know about target-date funds.
First, a brief primer: The concept of a target-date fund is tied to an employee’s projected retirement date. At regular intervals, the funds are automatically adjusted, or balanced, between different investment holdings to reflect market behavior. Additionally, as the employee’s projected retirement date gets closer, a target-date fund’s holdings are automatically moved out of stocks and other higher-risk investments and into bonds and other traditionally lower-risk holdings. These “glide paths” are designed to reduce the risk of being impacted by a market correction from which the account owner cannot recover as they near retirement.
The most positive aspect of target-date funds is that they are simple. They offer a broad mix of investments without much of the head-scratching and intimidation that employees may face when choosing individual funds within their retirement plan. It can seem much easier to pick a fund by matching the date to your retirement goal than it is to choose from a list of funds that might seem overwhelming. Is simple better?
The reality is that the typical target-date fund looks at only one criterion: when you plan to retire. It does not take into account individual circumstances, including personal risk tolerance, current wealth, other assets, current income, and expected income in retirement. The “one-size-fits-all” aspect might not fit in with the specifics of your financial plan.
Let’s talk fees, because they are a hot topic with target-date funds. Investors should understand 401(k) fees so their retirement contributions can work as hard as possible for the participant. Target-date funds have a tendency to have higher fees than other retirement plan options, as there is a fee for the underlying mutual funds and potentially another layer of fees for managing the funds. Competition has driven expense ratios lower over the past few years, but fees are still an important factor.
Target-date funds are often comprised of mutual funds from one particular fund family (Fidelity, John Hancock, etc.), which can lead to similar investment styles across the underlying mutual funds and unwanted overlap. The concept of diversification becomes more important in such cases and should be a top priority.
Target-date funds are certainly a step in the right direction, creating diversified portfolios for investors that rebalance to become more conservative over time. However, investors may have the ability to build an even better, more customized allocation with the help of an advisor. Don’t take the easy way out. Your retirement account will thank you.