Many 401(k)s offer target-date funds as a simple retirement savings solution. But despite their popularity, a lot of people don't understand how they work. Just one in five workers say they understand target-date funds very well, according to a recent Employee Benefit Research Institute (EBRI) Retirement Confidence Survey.
That leaves a lot of room for improvement. If you'd like to test your knowledge of target-date funds, you can start by answering the following four questions.
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1. What is a target-date fund?
A target-date fund is a mutual fund or exchange-traded fund (ETF) containing assets that grow more conservative as you approach a specific year. The target-date fund you choose should match up with the year you plan to retire.
Because investors generally want to become more conservative with their holdings the closer they get to retirement, these funds offer the benefit of being hands-off investments that automatically adjust your asset allocation over time so you don't have to worry about doing it yourself.
2. What is the target date for the fund you're invested in?
If you're already invested in a target-date fund, you should know what the target year for that fund is. Most of the time, this isn't too difficult to find out because target-date funds list their target years in their names.
Look this up if you don't already know the answer and make sure yours corresponds to the year you plan to retire. If not, you may want to move your money into a different target-date fund or other investments that better match your risk tolerance.
3. What is the target-date fund's glide path?
A target-date fund's glide path determines how the mix of assets in the fund changes as the target date approaches. Each fund has its own glide path and mix of assets, with some becoming more conservative more quickly than others. This can affect how much you earn from the fund and how much risk you're exposed to.
Some target-date funds have "to" glide paths, which reach their most conservative asset mix in the target year. That means the asset allocation in the fund won't change anymore after that point. Others have "through" glide paths, which don't reach their most conservative asset mix until after the target date.
It's up to you to decide which one suits you best. "To" glide paths transition to conservative investments more quickly, and this can reduce your risk of loss. But it often means you have a lot of your savings in bonds as you approach the target date, and these don't generate as much of a return as stocks can. As a result, you may not earn as much on your investments each year as you could with a less conservative portfolio.
4. What are its fees?
All investments carry fees, and some target-date funds can be pretty costly with expense ratios of 1% or more. That might not sound like much, but it means you're giving away $1 each year for every $100 you have in the fund. If you have $100,000 in the target-date fund, you're losing $1,000 per year with a 1% expense ratio. High fees eat into your profits over time, so you want to keep them as low as you can.
Look at your prospectus for the target-date fund to find out how much you're paying each year. It's probably going to be listed as an expense ratio -- a percentage of your assets -- not a flat dollar amount. Compare this to the expense ratios on some of the other funds available to you through your 401(k) to see how it stacks up, and try to keep your fees under 1% of your assets whenever possible.
Answering these questions may not tell you everything you want to know about your target-date fund, but it should help you get a sense of whether it's right for you and how its asset allocation will change over time. Check in on the fund once in a while to see how it's performing, and make sure it's still in line with your retirement goals. If your plans for retirement change, you may want to switch up your investments as well.
