You may have heard the term "target-date fund" thrown around in the context of retirement planning. But how much do you know about these funds and how they work? If you're relatively clueless, you're in good company. Only about 50% of workers say they understand how target-date funds work, according to a recent survey by the Employee Benefit Research Institute. If you're eager to learn more about target-date funds, here are a few things you should know.
How do target-date funds work?
A target-date fund is an investment fund that automatically adjusts from higher-risk to lower-risk as a specific milestone draws near. For example, if you put money into a target-date fund within your retirement plan, the target date in question is the year you might retire.
Target-date funds are commonly found in 401(k) plans. In fact, when you first enroll in an employer-sponsored retirement plan, that plan's default savings option is likely a target-date fund.
What are the benefits of target-date funds?
Target-date funds are useful for one big reason: They take a lot of the guesswork out of long-term investing. Imagine you're 37 years old and your anticipated retirement age is 67. You should, ideally, be investing your retirement savings aggressively at this stage of life, when retirement is years away. But as retirement gets closer, you should gradually shift toward safer investments. With a target-date fund, you don't really have to think about doing that. You just choose a target-date fund, or stick with the one your retirement plan defaults to, sit back, and passively watch your investments adjust over time.
What's not so great about target-date funds?
Though target-date funds take the guesswork out of long-term investing, they're not perfect. For one thing, target-date funds don't take your personal needs or tolerance for risk into account. Maybe you're the type of person who can withstand a little more risk -- which could result in higher reward -- closer to retirement. Target-date funds assume an equal level of risk tolerance among all savers, but that may not align with your views.
Along these lines, target-date funds are sometimes too conservative across the board. And sticking with one could cause you to fall short financially during retirement.
Target-date funds can also be expensive. The funds you're offered in your 401(k) all come with what are known as expense ratios, which are effectively the fees you pay for the privilege of investing in those funds. Index funds are an affordable option in this regard -- their expense ratios tend be low. But with a target-date fund, you may be looking at higher fees that eat away at your returns.
Is a target-date fund right for you?
A target-date fund is a good idea if you know you truly don't have the patience to actively manage your long-term investments. But if you're willing to do some legwork, you may find that you're able to establish a more suitable retirement portfolio at a lower cost.
Of course, there's no rule stating you need to keep all of your assets in a target-date fund, so what you may opt to do is invest a portion of your retirement savings in one of these funds, but spread your remaining assets out over different choices. Finally, if you're going to favor a target-date fund, research it thoroughly. See how it's performed historically and read up on its fees. The more diligent you are, the greater your chances of amassing enough savings to support a comfortable lifestyle once retirement finally rolls around.