Target-date funds (TDFs) are one of the most popular investment options offered by employers because they provide employees an all-in-one portfolio within their retirement plans. To show how popular they are, more than 70% of all 401(k)s provide TDFs, and approximately 50% of participants own them. However, most employees don’t even know what target-date funds are or how they work.
So why the fuss about target-date funds? Although popular, many participants are misusing them and hurting themselves in the long run.
What a Target-Date Fund does:
A TDF is simply an investment fund that owns a bunch of index-style mutual funds. Because TDFs include funds with broad exposure to different types of assets, they allow novice investors to access countless stocks and bonds. For example, the Vanguard 500 Index Fund tracks the S&P 500, which gives investors access to 500 different stocks. A TDF may contain several funds similar to the Vanguard one.
According to a recent study by Aon Hewitt, retirement savers who choose to invest in a single TDF and no other funds had higher investment returns by over 2%. In addition, those participating in TDFs outperformed people who manually managed their retirement investments by a whopping 3%.
Here are some reasons they have been misused, how to overcome them, and why you only need one in your portfolio.
Choosing the wrong year
The name “target-date fund” means exactly what it sounds like. You choose a fund based on the year or “target date” that you plan to retire. TDFs are offered in five-year increments — 2035, 2040, 2045, 2050, and so on. Your goal is to pick a TDF associated with a date that is closest to when you expect to retire.
For example, if you’re 25 years old today and plan to retire at age 65, you would opt for a 2055 TDF option.
Why does the year matter so much? Because the closer you get to retirement, the more conservative your investments should become. This is important, because you have less and less time to bounce back from setbacks as you get closer to retirement. The way TDFs work, they tend to be more heavily invested in risky assets like stocks in your early working years.
“As the investor ages and moves closer to their intended retirement date, a target-date fund will reduce the overall investment risk,” explains John Croke, a certified financial adviser with Vanguard. This process is known as the glide path.
Choosing more than one TDF
Since TDFs are pretty straightforward, many people mistakenly think that they need to split their retirement savings among more than one TDF in order to be truly “diversified.” But the whole point of a TDF is that you only need to invest in one — it is automatically diversified among many assets for you.
“TDFs are designed as ‘all-in-one’ solutions that provide automatic diversification across multiple asset classes,” Croke says. “Owning more than one TDF is not advised or necessary.”
You shouldn’t treat your TDF as if you were a day trader trading stocks either. It’s better to invest in your TDF and keep your funds there rather than to jump in and out trying to time the market.
Paying too much in fees
Compared to traditional mutual funds, TDFs are especially appealing because they charge such low fees. In the world of investing, fees come in many different forms, but the important fee to watch out for is called the “expense ratio.” This is the amount your fund manager charges you for the ability to own that fund. Expense ratios can be as low as a fraction of a percentage or as high as several percentage points. It may not sound like much of a difference, but even a difference of one or two points can mean losing tens of thousands if not hundreds of thousands of dollars over the decades until you retire.
Also, participating in more than one fund just subjects you to more fees that are unnecessary. Why pay more when you don’t have to?
The final word
All in all, TDFs provide an easy, diversified, and low-cost means to invest for retirement. All you need to do is choose one that matches the year you plan to retire, make tax-deferred payments from your paycheck into the fund, and allow your account to grow with history proving that time is on your side when it comes to the markets.