Target-Date Funds: What Are They And Should You Use One In Your 401k?
Using a target-date fund can be a simple way to ensure that your 401k, Roth IRA, or traditional IRA is diversified and appropriately invested for your age. Because target-date funds don’t allow for you to make changes to the underlying investments, they also protect you from many of the most common investor mistakes. Individual investors tend to buy stocks when the market is high and sell stocks when the market is doing poorly. Investing in a target-date fund will protect you from making poor trading and allocation decisions (an allocation is the percentage mix of investments in your portfolio for example 60% stocks and 40% bonds) and will keep you invested through good times and bad.
Deciding on which mutual funds to purchase and the percentage of each fund to put into your portfolio can seem daunting, especially if you don’t have much investment experience. A little investment experience is sometimes even more dangerous than none; if you are going to make your own fund selections, make sure you consult a professional to come up with an appropriate allocation. When dealing with your retirement money you can’t afford to make major allocation mistakes. If you don’t want to make allocation decisions then a target-date fund may be a good option for you.
What is a target-date fund and why you might want to use one
Target-date funds are set up to give you the appropriate risk exposure and asset allocation for your age based on your expected retirement date (the date on the fund you select should nearly correspond with your expected retirement date). By maintaining an appropriate risk level and allocation for your age, Target-date funds take the allocation and risk options out of your hands and give that responsibility to the target-date fund’s portfolio manager.
According to the SEC, “asset allocation is important because it has major impact on whether you will meet your financial goal. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal… if you include too much risk in your portfolio, the money for your goal may not be there when you need it.” If you don’t feel like seeking financial advice and researching how you should allocate your 401k or retirement assets then a target-date fund is for you.
In addition to asset allocation, target-date funds also take care of portfolio rebalancing. Portfolio rebalancing is the act of selling the assets that are doing well and buying assets that are performing poorly. This ensures that the investor does not end up with an inappropriate weight of any one asset class. While it is possible for individual investors to rebalance their own portfolios, a target-date fund ensures that this will be done without having to log into your account and rebalance manually.
What investments are typically in target-date funds?
Fund companies typically select one fund from each of a few major asset classes such as U.S. stocks, international stocks, U.S. bonds, international bonds, other fixed income (such as TIPS), cash, and alternatives. Once they have the mutual funds or ETFs (exchange traded funds) selected that they will use in their target-date fund, they put together appropriate allocations among those funds for every age.
Below is an example of Vanguard’s target-date fund allocation and how it changes over time. The allocation begins to shift towards bonds and away from equities when you are 25 years away from retirement and continues to shift until a few years after you have retired.