A one-step, no-hassle strategy for saving for retirement? Who wouldn’t be interested in that?
That’s essentially what target-date funds are, and if you’ve ever invested in a 401(k), you’ve likely heard of them before. But is a one-size-fits-all retirement plan really the best choice for you?
Brandie Farnam, CFP®, a financial planner at LearnVest, let us in on everything you need to know about target-date funds—and whether they’re right for your retirement strategy.
What Is a Target-Date Fund?
When most people in the industry define a target-date fund, they use a lot of jargon. Case in point: According to Farnam, this is the official definition: “A mutual fund allocated across different asset classes that's meant to act as an investment glidepath.”
In general, when you’re young and have ample time before you're ready to retire, you can take on more investing risks. Broadly speaking, this means a portfolio with more stocks than bonds. But, as your target-date draws closer, your investment mix should become more conservative. So if you were managing your own investments, this would require paying attention to how much of each type of investment you have and rejiggering accordingly every year.
Of course, realigning your investments annually can be a handful. That's where target-date funds come in—they basically do the work for you.
In layman's terms, a target-date fund is a mixture of investments—like stocks and bonds—that are selected for you based on the amount of time that you have left before retirement. As you get older, the target-date fund will automatically shift your portfolio into investments generally considered to be less risky.. You may hear this referred to as the "glidepath," which sounds a lot dirtier than it is—it's the way the fund reallocates your money as you get older, gliding you down a more secure path.
Are Target-Date Funds a Good Idea?
Overall, Farnam says that target-date funds are a solid option, especially for new or relatively inexperienced investors. This is “the most hands-off option when it comes to investing for retirement,” she says.
Of course, a low-maintenance approach doesn’t mean that you can get away without doing some homework of your own. Farnam offers three tips for choosing the best target-date fund suited to your needs:
1. Look at the expense ratio.
The expense ratio is what it costs to manage the target-date fund. It's a fee that will get taken out of your savings to pay for operating expenses. “I would ideally like to see an expense ratio under 0.8%,” says Farnam. “Above 1.2%, I would be concerned.”
While a 1% fee might not seem like a lot of money, it can add up significantly over time. You can determine a fund's expense ratio by using such online resources as Morningstar or your online brokerage's own research tools.
2. Investigate the allocation.
Farnam's rough guide for figuring out your ideal allocation: The percentage invested in stocks should be 120 minus your age.
If you are 30 years old, your number would be 90, which means that you should have 90% of your portfolio invested in stocks. The remaining 10% should be in safer investments, like bonds. As you get older, your portfolio will become more heavily weighted toward bonds. So at 40, your portfolio should roughly contain 80% stocks and 20% bonds.
Bottom line: As you look at potential target-date funds, make sure that the fund's current allocation aligns with the above formula for your current age. If it doesn’t, it may mean that the fund managers are slightly more or less aggressive with their selection of the asset allocation model, and you might consider choosing an option for someone five years older or younger than you.
You can determine a fund's asset allocation by reading its prospectus or by looking up its ticker symbol via an online resource, like Morningstar.com, which breaks down what percentage of the fund is invested in U.S. stocks, non-U.S. stocks, bonds or cash.
3. Focus solely on the option for your expected retirement age.
Farnam says that the biggest mistake people make is splitting up their retirement investments between multiple target-date funds—one for their correct expected retirement age and one for an age group that's older or younger than they actually are, in an effort to diversify.
The thing is, the underlying holdings in most target-date funds are usually the exact same holdings, just in different percentages, so you defeat the purpose by trying to craft a mix of investments that falls between the models optimized by a fund manager.
Your best bet is to use the rule of thumb given above to determine the percentage of your investments you want in stocks, then find a target date fund near your projected retirement date that mirrors that mix.
Are There Downsides to Target-Date Funds?
"In my opinion, not really," says Farnam. “Some people argue that target-date funds are too aggressive, that you don’t know quite how much risk you’re taking," she says. "But they’re in line with the correct mix the majority of the time.” As long as your allocation is correct, and the expense ratio is relatively low, she adds, you should be good.
"So don’t feel bad about going with the easy option for retirement," Farnam says. If the time or effort of dealing with your investments has been keeping you from putting money away for retirement, it's much more important that you just get started. Best of all, once the above research is out of the way, you can set it and forget it—and be on your way to reaching your retirement goals.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.