Contrary to popular belief, managing your 401(k) doesn't have to be labor-intensive. Sure, some 401(k) portfolios require maintenance tasks like rebalancing. But there's one 401(k) investment that functions as a portfolio on its own and manages your risk over time, too. It's called a target-date fund, or TDF.
A TDF can grow your retirement wealth with little involvement from you. Here's a closer look at how TDFs work to streamline your 401(k) savings efforts.
What are TDFs?
TDFs are funds that invest in a strategic blend of stocks and bonds. The blend is strategic because it's designed to suit your retirement timeline. The fund accomplishes this by targeting a specific retirement year, which you'll find in the fund's name.
Image source: Getty Images.
You'd invest in a 2050 TDF, for example, if you expect to retire in 2050. The fund's target year is also known as the vintage.
Changing investment needs
What's tricky about retirement investing? Your needs change as you near your planned retirement year. For example, you can invest aggressively when you're young because you have time to ride out any volatility. But if retirement is within five years, you're wise to be more conservative, in order to protect your wealth from any big market dips.
You could manage this transition manually by changing your investment settings and rebalancing your portfolio every year. But you don't have to complete those tasks when you own a TDF because they automatically shift to a lower-risk portfolio as the target year approaches.
Choosing the right roadmap
TDFs reduce risk over time by gradually lowering the portfolio's exposure to stocks and increasing exposure to bonds. The roadmap that defines this transition is called a glide path. What can be confusing for 401(k) savers is that two funds with the same vintage can have dramatically different glide paths.
As an example, some glide paths reach their most conservative point in the target year. Others delay the most conservative point to sometime after the target year. The delayed approach is riskier, but offers more growth potential.
Understanding that difference can help you choose the right TDF for your situation. Chances are, you have one family of TDFs available in your 401(k). If you don't like that fund's glide path, you can address it by choosing a different vintage. An earlier year would be more conservative, while a later year would be more aggressive.
For example, say you plan to retire in 2050. You see that the glide path for the 2050 fund in your 401(k) reaches its most conservative point in 2055, or five years after the target year. If that's too risky for your taste, invest in the 2045 fund instead.
A 2045 fund in the same family will also settle into its most conservative portfolio five years after the target year. In this case, that would be 2050 -- your planned retirement date.
No rebalancing or other investments required
Because TDFs are so structured, they're intended to be the only asset in your retirement portfolio. Combining other funds with a TDF would change your risk profile and defeat the purpose of the glide path.
With only one fund in your 401(k), you don't have to rebalance or trade. Your main responsibility as a TDF shareholder is to check in on the fund's performance versus peers periodically.
You may decide on a different approach if the fund performs poorly. Otherwise, you could leave your TDF alone indefinitely.
The downside of TDFs
TDFs are easy to own, but they do have drawbacks. The main disadvantage is that a TDF doesn't address your individual needs.
For example, you might have a low risk tolerance, the intention to retire early, and a projected lifespan of 100. In that scenario, you must cater to your risk aversion while generating enough wealth to remain solvent for 40 years without a paycheck. That's a tricky balance -- and one that probably isn't solved by a one-size-fits-all glide path.
Hands-free retirement saving
If you want to manage your 401(k) without lifting a finger, investing in a TDF might be your answer. The bulk of your effort will be upfront -- reviewing the glide path and choosing the right vintage. After that, there's not much to do except contribute and wait for your wealth to blossom.
