You can't just choose your investments once and forget about them until retirement. Your needs change over time, and your goals might too. The best portfolios adapt to these changes, but many investors don't feel confident picking their own stocks.
To make things easier, many employers offer target-date funds to their employees through their 401(k)s. But only about half of workers understand how these work, according to a recent Employee Benefit Research Institute (EBRI) survey. That's a problem.
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If you plan to invest in target-date funds, you need a basic understanding of how they operate to be sure you've chosen the right one. So let's take a closer look at them.
How do target-date funds work?
Target-date funds are bundles of investments designed to adapt to your changing risk tolerance. When you're young, it invests more aggressively, with a higher percentage of your savings in stocks. Over time, it gradually moves more of your money to safer investments, like bonds, to protect what you have. And it does all this automatically, so you don't have to worry about picking investments on your own.
As the name implies, target-date funds are built around a target date. This is supposed to represent the year you plan to begin using your funds. For example, if you plan to retire in 2040, you'd want to invest in a 2040 target-date fund. Most target-date funds include the target year in their name, so it's not too difficult to figure out which ones are suitable for you.
But don't assume all target-date funds with the same target year are the same. For starters, some are "to" funds, which reach their most conservative asset allocation in the target year and don't change their investments after that. Others are "through" funds, which continue to grow more conservative even after the target year has passed. Target-date funds also have their own combination of investments, which affects how quickly your savings grow and how much you pay in fees.
Are target-date funds a good investment?
Target-date funds can be very convenient, especially for those who don't feel confident picking their investments. This is part of the reason so many employers offer them through their 401(k)s. They offer instant diversification, and once you've chosen one, you don't have to do anything other than keep adding money to your account.
But the automation these funds provide may not be a great thing if your retirement plans change. Target-date funds are designed to follow a particular path, and they're not tailored to the needs of an individual. If you decide to retire earlier or later than you originally intended, your target-date fund may no longer suit you.
They also aren't the cheapest investments to own. Target-date funds are mutual funds, and these charge expense ratios -- annual fees charged as a percentage of your assets. Moreover, they're often funds of funds. That means you have to pay the expense ratios for all the funds in the target-date fund in addition to the target-date fund's own expense ratio. All these fees can slow your savings' growth.
It's ultimately your decision whether to invest in a target-date fund. It could be a good fit if you don't feel comfortable managing your investments on your own. But it never hurts to explore all the options available to you before making that call.
How do you choose a target-date fund?
The first step in choosing a target-date fund is to decide upon your target year. Often, target-date funds are created for years ending in 5 or 0. For example, you might see target-date funds for 2045 or 2050. If you plan to retire in a year ending in a different number, you may have to opt for the closest target-date fund you can find.
Once you've chosen your target year, dig deeper into the funds with that year that are available to you. Look at what the funds invest in and their glide paths, which outline how the funds' asset allocations will shift over time. Be sure to check into the accounts' fees as well.
Go with the fund you feel best aligns with your current retirement plan. And should your plans change, don't forget to revisit your target-date fund to see whether it's still a good fit for you. You may need to find a new target-date fund that better suits your new retirement timeline.
