Your 401(k) can be the most powerful tool at your disposal when it comes to building wealth for your retirement. Between a decent contribution limit, tax advantages, the potential for an employer match, and automatic investing straight from your paycheck, such plans are very hard to beat.
If there's a challenge with 401(k) plans, it's this: you have to figure out how and when to manage the money in your account. It makes sense to adjust your investments at different ages and life stages, and that generally takes time, effort, and know-how. Fortunately for those looking for the ultimate in simplicity, there is one approach available in many plans that can let you manage your 401(k) without lifting a finger after you initially set it up.
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Your one-stop-shop for retirement investing
That approach relies on something known as target date funds. Those funds start out investing aggressively, and then they get more conservative over time as your retirement date approaches. To use them, all you need to do is set up your payroll deduction amount, direct it toward a fund with a date around the year you expect to retire, and then stay employed until then. That makes target date funds a superb option for people who want the absolute simplest approach to managing their money.
While you're young and have the benefit of time to let compounding work, the aggressive investments in those funds have the opportunity to grow on your behalf. As your retirement date approaches and certainty becomes more important, the funds convert to a higher concentration of bonds to provide more stability as you plan and begin taking withdrawals.
Are there any downsides to investing this way?
As with any investment, however, there are trade-offs involved in using target date funds vs. other approaches. First, such funds tend to be structured as "funds of funds" -- which means the assets the target date fund holds are typically other mutual funds. That means you'll face two layers of management fees and friction costs from any trades the investments have to make. That has the potential to lower your returns a bit versus simply buying the underlying funds.
Second, those funds tend to be managed a bit more conservatively than may be optimal for your specific case. For instance the Vanguard Target Retirement 2065 Fund (NASDAQMUTFUND: VLXVX) has around 10% of its assets invested in bonds and short term reserves. That date is more than 40 years away, which makes it likely that the bond and cash-like allocation will be a drag on the portfolio's long-term performance.
Sure, there are great reasons for even younger investors to hold cash and/or bonds to cover emergencies and near-term expenses. For money locked away inside a retirement account and largely untouchable for more than four decades, the case for bonds and cash gets a bit weaker.
Third, by designing around the average case for a specific retirement year, target date funds may not do all that great a job of meeting your specific needs. For instance, the Vanguard Target Retirement Income Fund (VTINX 0.39%), which is the in-retirement stage of its target date funds, has around 70% of its investments in bonds and short term reserves.
That allocation might work fine if your sole concern is covering your costs from your portfolio for the next few years. If you're looking to leave a legacy, are concerned with long run inflation, or if you find yourself with more money than you strictly need, that may be a too conservative set of investments.
Still a great choice if you really want to spend no time on your future
Despite those trade-offs and limitations, if what matters most to you is minimizing your need to think about your retirement while still saving for it, target date funds make a great choice. After all, they offer an opportunity for more growth when you're early in your career and more stability when your career winds down, all without you having to make any moves on your own.
When paired with a contribution strategy that increases over time -- such as auto-escalating contributions based on a percentage of your salary -- they provide the core of a solid overall plan. Just recognize that in your quest for simplicity, you're trading away opportunities for faster growth and a more personally tailored plan.
If those trade-offs are worth it to you for being able to build a retirement account balance without having to put much thought behind it after you set things up, then put that plan in place. It is certainly a better strategy than not saving anything at all for your retirement, and it can help you build a decent net worth over time.
Get started now
Regardless of how you choose to save for your retirement, the sooner you get started, the better your chances are of building a comfortable nest egg by the time you need to tap it. Target date funds provide a great way to make investing for your future a one-decision event. If that's what it takes to get you investing, then make the decision now, and put yourself on track for a more financially comfortable future. Your future self will thank you for it.
