You can probably get by in life without fully understanding chemistry, philosophy, or even algebra. But getting confused about a common investment choice in your 401(k)? That could cost you.
In 2019, MetLife commissioned research among employers, workers, and retirees to understand investors' opinions on their prospects for retirement and their retirement benefits. A key section of that research centered on target date funds, or TDFs. TDFs are popular within 401(k)s; more than 90% of MetLife's surveyed employers offered TDFs as an investment choice within their retirement plans. Despite the popularity, workers and retirees showed a stunning level of confusion about how TDFs work. Specifically, 46% respondents didn't know that the "target date" is the investor's expected year of retirement. And only 51% of respondents knew that TDFs hold stocks, bonds, and other assets.
Image source: Getty Images.
If you're invested in a TDF, it's time to clear up any confusion right now. You'll have a more accurate view of your retirement plan, you'll make better investing decisions, and, as a bonus, you can be the new TDF know-it-all at cocktail parties.
TDFs contain stocks, bonds, and other investments
A TDF is a collection of stocks, bonds, and other investments, sold under one ticker. Just like a mutual fund, a single share of a TDF gives you fractional ownership of an entire, diversified portfolio.
The target date is the year you plan on retiring
The target year in a fund's name dictates the fund's asset allocation, and asset allocation is a strategy for managing risk. Since the fund's risk level is tied to the target year, it's critical to know this TDF fact: The year in the fund's name is your expected year of retirement.
Asset allocation in TDFs gets more conservative over time
TDFs have one distinct feature that sets them apart from other funds. A TDF's asset allocation gradually moves from risky to conservative as that target year approaches. Vanguard Target Retirement 2065 Fund (NASDAQMUTFUND:VLXVX), for example, is designed for those who plan on retiring in 2065. Since 2065 is several decades away, that fund is invested aggressively for long-term growth. You can see this in the fund's allocation, which is 89.4% equities and 10.6% bonds.
Vanguard Target Retirement 2030 Fund (VTHRX -0.23%), on the other hand, holds 67.5% equities and 32.5% bonds. This fund is invested more conservatively, because the targeted retirement year is much closer and asset protection is a greater concern.
Same-year TDFs can follow different strategies
Only 39% of investor respondents in the MetLife report understood that two TDFs with the same target year can follow very different strategies. They can and they do. Don't assume all TDFs for your expected retirement year match your risk tolerance. Review a fund's asset allocation -- you can find it in the prospectus -- to ensure you're comfortable with the risk level. Then, set a reminder on your calendar to check in on the fund's composition every couple of years, or more often if you are close to retirement.
Your overall asset allocation is what's important
TDFs are intended to be an easy, hands-free solution for retirement savers. If you're only invested in a TDF, you don't have to rebalance your portfolio, ever -- the automatic adjustments to the fund's asset allocation handle that task for you. But realistically, you might have money stashed in a couple of 401(k)s and IRAs, with different investments in each. And that's when you have to start paying closer attention to the asset allocation within those TDFs.
Say you have an IRA with equities funds and a 401(k) that's invested in a TDF. Your allocation in the TDF might be appropriate, but your overall allocation is skewed toward more risk because of those equities in your IRA. The bottom line? If you don't want to pay attention to your asset allocation at all, you'd have to limit your retirement investing to a single TDF.
TDFs offer no guarantees
Unfortunately, this is another misunderstood aspect of TDFs. Only 41% of investor respondents in the MetLife research recognized that investing in a TDF doesn't guarantee enough money to cover living expenses in retirement.
TDFs are investments. Like stocks and mutual funds, they can gain or lose value. You hope investing in a TDF will grow your retirement savings over time, but there are no guarantees of earnings or income in retirement.
Saving is your best guarantee
At this point, algebra's quadratic equation might sound like a more upbeat topic than the TDFs in your 401(k). It's understandable, particularly if you'd hoped the TDF would automatically secure a comfortable retirement. But there's good news. The factor with the most influence over the growth of your retirement fund is how much you save. Aim to save 15% of your income for the long term. Invest that money -- in a TDF or another low-cost fund -- and you're well on your way to the retirement you want.
