Should you invest in target-date funds?
Fretting about retirement planning? Here’s a mental exercise: Picture yourself lounging on the beach. Or doing crossword puzzles on the porch. Or skydiving over the mountains of New Zealand. Everyone’s got a different plan for life post-work.
Today we’re going to talk about one smart way to get there: target-date funds.
Target-date funds are one of the most popular investment options in the country, with $880 billion invested in target date funds as of 2016.
The idea is that they make retirement planning super simple. Here’s how it works: When you set up your 401(k), IRA, or other plan, you might have the option of investing in target-date funds, which target the date you’ll retire. This mix of funds automatically readjusts to be riskier when you’re young (more stocks than bonds) and more conservative as you approach retirement (more bonds than stocks). This can be especially attractive to beginner investors who are overwhelmed by 401(k) options or afraid to reallocate funds as they get older.
In fact, if you have a 401(k), you could be enrolled in one without knowing it. That’s because a 2006 law gave employers the right to make target-date funds a default option. Since then, they’ve become one of the most popular investment options in the country, with $880 billion invested in target date funds as of 2016.
But, like all investments, there’s risk involved. If you’re considering target-date funds (or if you’re already invested in them), here are some questions to ask:
1. What’s the risk? Remember: With target-date funds you may be off the hook for picking stocks and bonds, but you can still lose money. In 2008, investors in target-date funds who were on the verge of retirement saw their accounts plummet by 23%, and some lost as much as 41%. To put this in perspective, if you had $500,000 in a fund with a target date of 2010, you would have lost over $200,000! Does that mean you shouldn’t invest in these funds? Not necessarily. Target funds rebounded in subsequent years, with the average TDF 2010 fund returnING 22.4% in 2009, according to a study by Morningstar.
2. How will the investment mix change over time? In the world of target-date funds, the “glide path” refers to how often and how much your fund will adjust to become more conservative. “Keep tabs on that allocation once a year to see overall how much is in stocks or bonds,” advises certified financial planner Kevin Sale. You don’t have the ability to make adjustments, but you could pull out of the fund and invest in something else—it all depends on the level of control and risk you’re comfortable with.
3. What are the fees? When it comes to investing, one of the few factors you can control is how much you spend on fees—so pay close attention to a fund’s expense ratio. You can find this out via the fund’s prospectus or you can check FINRA’s Fund Analyzer. According to Morningstar, the average expense ratio for target-date funds in 2009 was 0.9%. Compare that to Vanguard’s index funds, which charge, on average, just 0.18%. That 0.72% difference might not sound huge, but look at it this way: If you were to invest $1,000 a year in an account with an average return rate of 6%, that fraction could cost you about $20,000 at retirement time.
Do you—or would you—invest in target-date funds?