Should You Put Your 401(k) Into a Target-Date Fund?

Over $650 billion of America's retirement savings are in target-date funds, and these investment vehicles are only getting more popular. Adored by 401(k) plan administrators and investors for their simplicity, target-date funds are expected to attract half of all defined-contribution plan assets by 2020.

So should you put your retirement savings into one? As with most things in finance, it depends on your needs and preferences.

What is a target-date fund?
Target-date funds are designed to be a one-stop shop for retirement savings. They hold portfolios of mutual funds, index funds, or ETFs, and the allocation is automatically rebalanced over time. The idea is that as you get closer to retirement, your portfolio should grow more conservative, in what is known as the "glide path" toward retirement. The allocations are all made for you, meaning you never have to choose another mutual fund or even consider what percentage of your assets should be in what category.

In addition to making things easy, automation also takes a lot of the emotion and stress out of investing. You don't need to second-guess yourself or worry about big-picture allocation decisions. In short, target-date funds are truly the simplest form of retirement investment -- a "set it and forget it" plan that doesn't require any ongoing oversight.

So should you go for it?
Whether or not you should invest in a target-date fund depends on you: If you enjoy investing and you want to tinker with your portfolio and keep costs to a minimum, then a target-date fund might not be right for you, as it takes these benefits away. Some people try to mitigate this by investing only part of their assets into a target-date fund. However, according to a study by Aon Hewitt and Financial Engines, from 2010 to 2012, those who invested only partially in target-date funds underperformed those who went in whole-hog by a median of 2.1% per year.

On the other hand, if you just want to participate in the market without having to think about asset allocation, rebalancing, or whether or not to increase your exposure to equities this year, a target-date fund might be just the ticket. Removing the headaches of managing your retirement money makes it easier to stay the course and focus on saving.

However, that doesn't mean that you can just pick any fund at random and call it a day. Take some time to understand the different target-date funds; given that you'll never have to do it again, this little bit of legwork is well worth it.

The 3 keys to target-date fund investing
There are three important issues to keep in mind when selecting a target-date fund:

  1. Whether your fund allocates to your retirement date or through your retirement
  2. The glide path of the fund -- i.e., how its allocation changes over time
  3. The fees you'll be paying

Let's take a look at these one by one.

1. Choosing between "to retirement" and "through retirement"
Some funds are most conservative right before the target date, while others stay heavily invested in equities to generate growth through retirement.

There are pros and cons to both strategies. A "to retirement" fund might miss out on growth that could help mitigate longevity risk, or the risk that you'll outlive your savings. But a "through retirement" fund is much more exposed to the market, so if equities decline significantly right around your retirement date, you might face the difficult decision of postponing retirement.

Know what you want in this regard and research your options to find a fund that will allocate your money accordingly.

2. Understanding glide path
Some funds rebalance a little bit over time, while others make sharper changes to the portfolio every once in a while. As with everything, there are costs and benefits to both. A gradual transition can protect your portfolio from sudden shocks, but it can also generate higher costs due to the frequency of the transactions and can also make it harder to participate in growth areas. Meanwhile, infrequent but more abrupt transitions can give you a shot at higher returns, but they're also riskier.

Further, if a fund's glide path is automated, you could end up selling at a bad time -- like when the market reaches its bottom. A recent Morningstar report found that, contrary to conventional wisdom, target-date funds whose managers can override the automatic glide path have actually outperformed their peers.

3. Don't forget about fees
Not all target-date funds are created equal when it comes to fees. Pay close attention to the expense ratio of your fund: Even a small difference in fees can eat away at your returns over time.

Some funds charge more to give you access to outside managers, but according to Morningstar, they don't have a demonstrable performance advantage. The same goes for funds that allocate to actively managed mutual funds, which are usually more expensive but don't generate better returns on average.

Take a hard look at fees and try to find the most compelling cost structure you can -- your portfolio will thank you.

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