What You Need to Know About the Easiest Way to Save for Retirement

By Tim Lemke on 9 May 2017 0 comments

If you have a 401(k), chances are you've been given the option to invest in a "target-date" fund. This is a balanced mutual fund that gradually changes its investment mix depending on how close you are to retirement. It's designed to hold a higher percentage of riskier, growth-oriented investments like stocks when you're young, and increase the proportion of more conservative investments, such as cash and bonds, as you age.

Many brokerage firms offer target-date funds, which come with names like Fidelity Freedom 2050 or Lifepath Index 2045. The idea is to pick one associated with the year you expect to retire.

There are advantages to these funds, especially for those who don't want to spend a lot of time managing their investments. But there are some drawbacks, too.

Pros

Let's start with the upsides.

1. They automatically rebalance

Target-date funds are designed to build wealth while you're working, and protect it as you approach retirement. They accomplish this by gradually and automatically changing the investment mix over time, which is referred to as rebalancing. Because it's not particularly easy for the average investor to make these kinds of changes on their own, a target-date fund offers the convenience of "set it and forget it," saving you time and extra work.

2. They are easy to select

Picking which mutual fund is right for you is tricky, because there are often so many choices. There are funds for specific industries, funds for growth, and others for income — it can be overwhelming. When choosing which target-date fund is right for you, though, all you need to do is pick one that lines up best with the year you expect to retire. So if you are now 30 years old and plan to retire at age 63, you would pick a fund labeled with the year 2050.

3. They offer diversification

Most target-date funds are essentially "funds of funds." In other words, they are comprised of a mix of mutual funds, which are already made up of a blend of stocks and bonds. Thus, investors are hardly at risk of placing too much of their money in any single investment.

Cons

All that convenience comes at a price.

4. They have high fees

If you invest in target-date funds, you can expect that fund managers and brokerage firms will take a bigger chunk of your money than they would for basic index funds. The Wall Street Journal reported last year that the average expense ratio on more than 2,200 target-date funds was more than 0.9 percent. Meanwhile, there are many basic index funds that have ratios of less than 0.1 percent.

An expense ratio measures what it costs an investment company to run a mutual fund, and is calculated by the fund's annual operating expenses divided by the average dollar value of its assets under management. Those operating expenses are taken out of the fund's assets and lower the return for investors. Over time, a higher expense ratio could impact your overall investment balance by thousands of dollars.

5. They aren't one-size fits all

Not everyone generates the same amount of income during their lifetime, and expenses in retirement can vary wildly. Thus, the right mix of bonds, stocks, and other investments will differ depending on the investor. Target-date funds don't take this into account. One investor may be able to retire comfortably with a portfolio of bonds and cash, while another might need more growth stocks to meet their retirement goals.

6. Funds with similar names may actually be quite different

There are thousands of target-date funds out there. Many of them have very similar names and similar goals, but differ in their investment mix. For example, the Fidelity Freedom 2035 fund is currently comprised of 64 percent U.S. stocks, 31 percent international stocks, and 5 percent bonds. The Vanguard Target Retirement 2035 fund, however, is 48 percent U.S. stocks, 32 percent international stocks, and about 20 percent bonds. Thus, the performance and risk of these funds may vary even if their names and goals are very similar.

7. They may not be aggressive enough for some older people

On one hand, you probably don't want to be investing in all stocks when you are approaching retirement age. But if you become too conservative, you might miss out on big returns. There are some financial advisers who argue that it's OK to stay aggressive in retirement as long as you have enough saved to endure a possible downturn. In fact, one 2013 study argued in favor of a counterintuitive approach to retirement saving — more conservative investing when you're young, and more aggressive investing as you get closer to retirement.

If you think you want a more aggressive fund than the target date that corresponds with your projected retirement age, you can always choose one with a later target date. For instance, if you're planning on retiring in 15 years, but want a fund that's more aggressive now, you might choose a 2040 or 2050 target date fund.

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