Target-Date Funds: Are You Using Them Correctly?
More middle class Americans are choosing to place their 401k money in target-date funds. In addition, a rising number of 401k plans use a target-date fund as its default investment.
A target-date fund allows you to choose your expected retirement year (usually in five or ten year increments.) It then invests in stocks, bonds, and cash equivalents, re-balancing regularly depending on performance and proximity to your selected end date.
Should you keep all your savings in a target-date fund? What are the pros and cons?
A Case Study: Meet Eileen
Eileen is 30 years old, and is excited about her new job with a consulting company. She worries a lot about her retirement, and gets nervous when she hears talk of a coming recession. She enrolls in her company’s 401k plan, which by default puts her savings in a 2050 target-date fund. 2050 is the year she is expected to retire.
Target-date funds are often best for Eileen and others who are investing without professional help. It is likely a better choice compared to copying a co-worker’s 401k allocation, or asking her uncle what funds to pick.
It significantly diversifies her investments. A 2050 fund will usually have four or more funds invested in U.S. stocks, international stocks, and bonds.
It will give Eileen freedom. Instead of being tempted to adjust her 401k each time she turns on the news, she can worry less knowing her 2050 fund will regularly adjust her portfolio. It will buy more stocks when those are selling at a bargain compared to bonds. Studies show that this "rebalancing" improves portfolio performance.
It will make her portfolio more conservative as she approaches retirement. At the start, most of Eileen’s money will be in stocks. By the time she retires in 2050, about half of her portfolio will be in bonds. Bonds provide stability, which Eileen needs when she starts withdrawing from her 401k.
Not all target-date funds are made equal. Some cost a lot more than others. If there are lower-cost alternatives in Eileen’s 401k plan, she can mimic a target-date fund and save money.
It may be too aggressive for Eileen’s comfort. Most target-date funds will place folks in their 20s, 30s, and early 40s in a portfolio of 90% stocks and 10% bonds. This portfolio can lose 40% of its value in any given year. Those kind of wild swings are only appropriate for people with a high tolerance for risk.
Target-date funds are great options for those who are investing on their own. It provides excellent diversification, and automatically adjusts one’s portfolio. But be aware of the fees involved. They may only be suitable for those who will not panic when stocks dive.
For Eileen’s case, she may decide to still choose a target-date fund, to steer her away from making random or uninformed decisions. But she may opt to pick a 2035 fund, which is slightly more conservative than a 2050 fund.