Have you ever started a job and enrolled in the company’s 401k plan even though you had no clue what you were doing? If that’s you, I’m sure you have spent ample time on my website reading my insightful articles to help you! Today, I’m going to help you understand what nearly every employer-sponsored retirement plan offers: target date funds. By the end, you’ll understand what they are and how to pick one(if that’s the route you decide to take).
What are they?
Simply put, target date funds are mutual funds designed to simplify your investments for you, depending on what your retirement date is. These funds typically indicate a year in the name, such as 2040 or 2050. You pick the year that most closely matches your expected retirement date. So, if I’m working in 2025 and expect to retire in 2050, I would choose the “Target Date 2050” fund in my 401k plan. That would be better for me versus a 2040 or 2060 plan. I’ll explain why below.
How do they work?
There are several investment principles behind target date funds. The most important ones to know about are “rebalancing” and what I’ll call “risk tolerance vs. time horizon.”
Here is how rebalancing works: let’s say you choose an investment worth $100,000 that consists of 40% stocks, 40% bonds, and 20% cash. After 1 year, the stock portion of your investments doubled in value and the rest of your investments remained flat. Now, your account has a total value of $140,000 and $80,000 of that is your stock portion. That means that your stock portion is 57% of your total portfolio, and your bonds and cash have dropped to 29% and 14%, respectively. Yet, when you setup the account originally, you wanted a 40/40/20 mix(like I originally laid out for you). “Rebalancing” takes place when your investments are reorganized to reset to the original mix. So, in this example, the account holder would sell a good bit of your stocks and bring the value of the stocks back down to $56,000(or 40% of the total portfolio) and purchase more bonds and cash to bring those values to the correct percentage. Target date funds automatically rebalance periodically, so you don’t have to worry about it. This eliminates a lot of work for you.
Here is what I mean by risk tolerance vs. time horizon: generally speaking, the younger you are, the more risk you can take inside your investments. Conversely, the closer to retirement you are, the more conservative you would be to minimize the chance of losing money when you’re about to retire. A 30-year-old could afford to invest aggressively because retirement is still decades away. A 63-year-old needs to avoid aggressive investments so his portfolio doesn’t tank right before his retirement date—causing him to push the date back or work indefinitely. Target date funds automatically adjust how aggressively the fund invests depending on how close you are to retirement. For example, a Target Date 2060 fund would be quite aggressive in 2025 because there are still 35 more years to go. If you held the fund from 2025 until 2059, then the “investment mix” inside the fund would gradually become more conservative as you approached 2060. In 2025, your mix might be something like 80% stocks/20% bonds. If you looked at the same fund in 2050, it might be 50/50 or 40/60, for example. I can’t give you the exact numbers here—I’m merely teaching you the principle behind it. In summary, the funds start on the aggressive side and end on the conservative side as you reach the destination year.
Are they good investments?
These funds are ideal for the “set it and forget it” type of investor. Personally, I don’t use them, but that’s because I am familiar with what to look for when choosing between a list of investments. I would encourage anyone who doesn’t regularly engage in the investment world to give these a serious consideration. In addition to the two reasons I provided earlier, they also perform well enough when compared to other mutual funds. Plus, if you pick one today and become an expert 10 years from now, you can change your investments inside your portfolio at any time(in most cases).
