Target date funds, or TDFs, have become very popular among investors in recent years. And if you’re opening a new 401(k), this may be an option to consider if you want to minimize the stress of adjusting your retirement strategy as you get older.
In the past, 401(k) participants would have to create their own blend of investments called an asset allocation, typically including an array of stocks, bonds and cash equivalents. Asset allocation should reflect the risk tolerance of the investor as well as the time horizon until the money is needed, usually retirement. Typically, a longer time horizon allows for greater risk, which might translate to a higher proportion of stocks and riskier investments, whereas a shorter time horizon warrants more conservative choices.
That means your investment strategy should include rebalancing the allocation periodically as the retirement or target date draws closer. And this requires monitoring investments and making decisions about what exactly to adjust from time to time.
But what if this could all be done automatically, with no action required on your part?
This is precisely what a target date fund aims to do. The manager of the fund constructs a strategy around a target date at which time the participant is expected to start withdrawing funds. This target date is typically the participant’s retirement date, although it can also be directed toward other needs, like a child’s college fund. The fund manager will periodically reallocate the investment mix, usually annually, to become more conservative as the target date draws closer.
Good for hands-off investors. TDFs can be an excellent option for those who tend to avoid managing their investments but still want a steady path to retirement.
Simplicity. In theory, choosing a TDF could be the only investment decision you make, although this strategy may not always be advisable. Be sure to consult a qualified investment advisor.
Less intimidating. If you’re not particularly interesting in learning about different asset classes, mitigating risk and other issues an informed investor should understand, then a TDF offers a way to easily hand those decisions over to a professional.
Not amenable to changing goals. If your investment goals suddenly change or you have to retire earlier or later than planned, you could find yourself poorly positioned if your money is invested in a TDF whose target date no longer matches up with your needs.
Potentially more expensive. As TDF’s are actively managed by a fund manager, they typically will have a higher expense ratio than a passively managed fund, such as an index fund - although it may be comparable to other actively managed funds.
Not all TDFs created equal. Different fund managers may manage risk differently. Even if two TDFs share the same target date, that doesn’t mean they will have similar investments. And this is important for a potential investor to understand before making a decision.
If your 401(k) offers a TDF, don’t hesitate to ask your financial advisor how the fund is structured and how often it’s rebalanced. And remember that even though you can “set it and forget it” when it comes to TDFs, you’re not locked in permanently. So do your research and see if this approach might be a good fit for you.