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Updated on Thursday, January 24, 2019
When it comes to investing in your future, understanding your options can be overwhelming. Trying to learn about stocks, bonds and mutual funds can be stressful, leaving you confused and maybe even causing you to put off saving for retirement entirely.
That’s where target-date funds can help. According to the Financial Industry Regulatory Authority, approximately 90% of employer-sponsored retirement plans, such as 401(k)s, offer target-date funds, making them a convenient choice for your investments.
But how do you choose a target-date fund? Below, find out how target-date funds work and how to select the best one for your situation.
What is a target-date fund?
A target-date fund is a fund offered by an investment company that aims to grow your investment over time until your retirement. You typically choose a target-date fund based on the year you plan to retire, such as a “2040 Fund.” Investments start off aggressive but become more conservative as you near retirement age to decrease the risk of losing money.
According to Alex Caswell, a certified financial advisor and certified financial planner with RHS Financial, target-date funds are often a good choice for beginner investors. “The No. 1 reason why target-date funds are appealing is because they are simple to understand and to implement,” he said.
Target-date funds allow someone to get started without having an in-depth knowledge of the stock market. “The advantages are their simplicity and cost,” Caswell said. “The simplicity allows an investor to actually get invested. There is a big information hurdle to getting invested correctly. A target-date fund can make this decision very easy and get someone started on the right path.”
Chances are your 401(k) plan offers some form of target-date fund, so you already may have invested in one without realizing it.
5 things the best target-date funds will have
There’s a lot more to choosing a target-date fund than selecting the first one you see with your goal retirement date. Instead, consider these five variables before selecting a fund.
1. Strong past performance
While a strong past performance doesn’t guarantee high returns in the future, it is a good indicator that the fund may be successful. Before selecting a fund, study its performance over the last 10 years. Find this information by reviewing the fund prospectus, which you can request from the investment company. Some companies even post the prospectus online.
2. Low fees
Fees play a big role in the performance of your target-date fund. High fees can eat up your returns, decreasing how much money your fund earns. That’s why it’s so important to search for low-cost funds.
According to Vanguard, a leading investment company, the industry average expense ratio for target-date funds is 0.50%. However, you can find lower expense ratios by shopping around. For example, Vanguard’s average expense ratio is just 0.13%.
3. A glide path that fits your goals
“Glide path” is a common term used in reference to target-date funds, and it’s an important one to understand. The glide path is the asset allocation of a target-date fund — or what percentage of your money is invested in stocks, bonds or other assets. There are several types of glide paths that vary depending on your comfort with risk.
A common misconception is that if you invest in target-date funds, you’re guaranteed to have enough money when you reach your goal retirement date. That’s not true. A target-date fund simply means that your investments will adjust their aggressiveness as you get closer to your goal date.
That’s why choosing an end date and glide path that match your retirement needs is so important. When you’re young and just starting out, you likely want an aggressive glide path that rebalances regularly to gradually become more conservative as you near retirement age. If you’re closer to retirement age, you want a more conservative path that protects your investments.
4. An end date that matches your retirement needs
One important thing to keep in mind is that some funds are set to run until you retire, while others run through your retirement. What’s the difference? A fund that runs only until you retire will reach its most conservative point upon reaching the date you select.
A fund that runs through retirement will continue to rebalance and get increasingly conservative during your retirement. It may not reach its most conservative point until you’re well into your 60s. You may get higher returns, but you’ll also have more risk with this approach.
5. A management style that fits your comfort level
When it comes to management styles, you have two options: passive management and active management. Passive management is when the fund is set to rebalance automatically and follows the stock market’s trends. Active management is when an individual or firm chooses investments and manually adjusts those investments to try to beat the stock market’s performance.
There is a lot of debate about which approach is best, so it’s important to choose a management style that fits your comfort level. Many people are fine with passively managed accounts, while others want a human professional’s touch.
Investing your money
Saving for your retirement is important, but with all the investment options out there, it can be tough to decide what’s right for you. Target-date funds help simplify the process, empowering you to invest in your future without having to understand all the nuances of the stock market.
By exploring your options and comparing target-date funds, you can choose the best one for you and start building your retirement nest egg.