The money you contribute toward retirement savings shouldn't just sit in cash. Rather, you'll want to make a point to invest that money so it grows into a larger sum over time and leaves you with a large enough nest egg for a comfortable retirement.
Now if you're saving for retirement in an IRA, you'll generally have a wide range of investment options, from index funds to individual stocks. With a 401(k) plan, you generally won't get the option to buy stocks on a company by company basis. Instead, you'll usually be limited to a number of different fund choices. These might include mutual funds, index funds, and target date funds.
A recent survey by the Employee Benefit Research Institute, however, found that four out of 10 Americans don't really understand how target date funds work. And that's a problem given how popular these funds are.
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The pros and cons of target date funds
A target date fund is a fund that adjusts your asset allocation as a specific savings milestone nears. In the context of a retirement plan, a target date fund might start you off with riskier assets when you're younger, and then shift you toward more conservative assets as retirement gets closer.
Target date funds are a very popular choice for 401(k) plans. In fact, often, when you sign up for an employer's 401(k) plan, its default investment option will be none other than a target date fund. This means that if you don't actively choose alternatives, your money will land in one of these funds.
Now that's not necessarily a terrible thing. One advantage to putting your money into a target date fund is that you take guesswork out of the equation.
To put it another way, target date funds basically run themselves. If you're a hands-off investor looking to limit your risk, you may find that a target date fund is a suitable choice for you.
But there's a big downside to investing in target date funds you should know about. For one thing, target date funds are notorious for charging high investment fees. Those could eat away at your returns over time, leaving you with a smaller nest egg.
Secondly, and perhaps equally problematic, if not more so, is that target date funds tend to err on the side of being conservative. You might think that's a good thing if you're really risk-averse. But investing too conservatively for decades could leave you short on income once retirement rolls around.
Do your research
You may decide that target date funds are an appropriate investment for your 401(k). Or you may decide you're rather steer clear of them.
Either way, it's important to understand how these funds work when making that choice. It's also important to understand what your alternatives look like.
You may, for example, prefer to put your money into mutual funds. Doing so could also mean facing high fees, but you might see higher returns due to a more aggressive approach to investing. And if the idea of paying fees doesn't sit well with you, you may decide to put your money into index funds, which simply track existing market benchmarks and aim to match their performance.
Either way, it's important to have a good handle on how your retirement plan is invested. This especially holds true if the funds you contributed to your 401(k) are already sitting in a target date fund because you never chose a different route.
