Limited investment choices, high fees and a lack of confidence in making good money decisions are often cited as barriers to saving. Fortunately, one option has been added to many employer retirement plans that should make workers think twice about participating: the target-date fund.
In this article, we will explain how this option can remove the skepticism around employer-sponsored plans.
The Addition of Target-Date Funds to Retirement Plans
Target-date funds are ideal for retirement plans because they significantly help eliminate the confusion and hassle of picking investments yourself. By choosing a fund with a target date that roughly matches your anticipated retirement date, you get a portfolio of stocks, bonds and cash that targets capital growth in the early years but becomes progressively more conservative as the target date approaches. Employees essentially have the ability to choose a mutual fund once and have the heavy lifting done for them. In case you are unsure about this novel class of fund, consider reading how target-date funds work to familiarize yourself with this retirement investment option.
As it became clearer that individuals as a whole were not doing a good job of preparing themselves for retirement, employers tried to help by adding simpler choices to investment menus, such as target-date funds, to boost savings rates. The government aimed to help by passing the Pension Protection Act, providing target-date funds a safe harbor provision as default investments in retirement plans. As a result, employers received legal protection for directing employee savings into these funds.
Clinging on to Target-Date Funds Toward a Hassle-Free Retirement
The presence of target-date funds as investment options benefits workers in a number of ways.
Automatic diversification – With target-date funds, there’s no need to worry about being broadly invested. Most are invested in at least four other funds (the Fidelity Freedom 2050 Fund (FFFHX) is invested in 27!), making the risk of being too concentrated or focused relatively low.
Automatic rebalancing – One of the biggest retirement investing risks is being too aggressive as you near retirement. This puts investors at risk of significant principal loss at a time when they can least afford it. Target-date funds help reduce that risk by automatically shifting away from risky assets and investing conservatively when you need to begin withdrawing money.
Lower fees – Target-date funds tend to be cheap because they primarily invest in low-cost index funds. Since so many companies offer target-date funds now, employers have the ability to negotiate even lower fees when deciding which funds to offer in the plan. Lower costs mean more money stays in your pockets.
The idea of locking up money in a retirement plan while you’re in your 20s may not sound appealing but the risk of not saving has even greater consequences. Even a small monthly investment can grow into a significant nest egg over time. In this context, you can check out our Retirement Investment section to learn about the different funds including some relevant target-date funds.
Take, for example, a 25-year old who saves just $100 a month and earns a modest 6% annual return. When he reaches age 65, that small monthly investment will have grown to $200,000. Granted, that amount of money alone won’t get you a private cottage on some secluded island but it will get you a lot closer to retiring on your own terms.
Are You a Suitable Candidate for Target-Date Funds?
While target-date funds make solid choices for those who might be confused or intimidated by the idea of constructing an investment portfolio or just simply don’t want to deal with the hassle of it, there are a few things that all workers should keep an eye on with these funds.
Make sure you’re comfortable with the risk – Target-date funds don’t take into consideration how comfortable you are with risk. A fund with a target date of 2050, for example, will be mostly invested in stocks. If you want to stay away from the stock market, choosing a fund based only on the target date probably won’t make sense.
Keep an eye on fees – Just because most target-date funds are low cost doesn’t mean all are. Target-date fund fees have been coming down but some still approach a 1% annual expense ratio. However complacent or confused you may be as an amateur investor, it is really important that you look for the lowest cost choices since expenses eat into account balances. In this regard, Vanguard funds tend to be some of the cheapest in the mutual fund industry.
One size doesn’t fit all – In case you are easily panicked with the thought of losing money in a short duration or you are an expert investor who wants to heavily customize your retirement investment portfolio, you can be better off by staying away from target-date funds. It must be noted that the allocation of a target-date fund is up to the discretion of the fund provider and not up to you. Moreover, there can be times when your fund loses money, like in a bullish market run; however, one needs to have the risk appetite to absorb those fluctuations and the confidence that the fund will meet the retirement objective in the long run. Two funds may both have a target date of 2050 but may look very different.* Instead of simply going after a target-date fund based on the fund’s date, try to look at its allocation to make sure it’s invested in a way you’re comfortable with.
If your employer-sponsored retirement plan offers target-date funds as an option, it might be time to reconsider enrolling. Target-date funds may be the best option currently available for those who wish to “set it and forget it.” Even active investors can benefit from a product that is diversified, automatically rebalances and is usually inexpensive. Even though target-date funds aren’t necessarily a perfect choice, they’re a better option, especially for amateur investors, than not saving at all or going for the risky do-it-yourself investment approach.