If you have access to a 401(k) plan, you have a prime opportunity to save well for retirement. That's because 401(k)s come with generous annual contribution limits. And also, many employers that sponsor these plans match worker contributions to varying degrees. Contribute enough money out of your own paycheck, and you may be in line for a bundle of free cash.
But the money in your 401(k) shouldn't just sit there doing nothing. If you want your retirement savings to grow, you'll need to invest that money. And target date funds are a popular means of doing just that.
Target date funds adjust your investment mix automatically based on how far or close you are to a specific milestone. In the case of retirement, a target date fund would start you off with riskier investments, like stocks, that have the potential to generate higher returns. Then, as retirement nears, that fund would shift toward less volatile investments to minimize your risk.
Vanguard reports that as of the end of 2020, 80% of its 401(k) participants were using target date funds. But is that a good idea for you?
The upside: Simplicity
There's a benefit to putting your 401(k) into target date funds, and it's not having to spend too much time figuring out where to invest your money. When you use target date funds, you're effectively putting the process on autopilot. In fact, 401(k)s commonly default to a target date fund so that if you put money into one of these plans but don't select specific investments, you'll land in a target date until you say otherwise.
The downside: High fees and an imperfect investment mix
While target date funds may be convenient, they have their drawbacks. For one thing, you'll often pay high fees when you keep your money in a target date fund. Those fees could eat away at your returns over time, leaving you with less money by the time your career wraps up.
Furthermore, when you invest in target date funds, you get no say in your investments. That may be OK with you, but it could also mean having your money invested in a manner that's too aggressive or too conservative for your taste.
What's the alternative?
The tricky thing about 401(k) plans is that they generally don't let you buy individual stocks. To do that, you'll need to open an IRA. As such, you may have to put your money into a fund whose investments you don't get a lot of say over.
But if you're going to go that route, it pays to look at index funds over target date funds. Index funds are passively managed funds that aim to match the performance of whatever benchmark they're tied to. An S&P 500 index fund, for example, will have the goal of matching the performance of the S&P 500 itself.
While it's true that you can't choose your investments within index funds, the benefit is that their fees can be significantly lower than what you'll pay to put your money into target date funds. And you may find that certain index funds better align with your risk tolerance than target date funds.
Convenient isn't always best
Target date funds are unquestionably convenient. And they're clearly very popular. But does that make them the ideal choice for your 401(k)? Not necessarily.
Before you settle on target date funds, explore the alternatives. You may find that there's a better way to put the money in your 401(k) to work.