If you have a 401(k), you may be investing in target-date funds (TDFs), also known as lifecycle funds, or considering them as an investment option.
TDFs are professionally managed funds that invest in various assets such as stocks and bonds, providing instant diversification. These funds might appeal to investors who prefer a “set it and forget it” approach, as they are willing to delegate investment decisions to professionals. It’s like putting your retirement savings on autopilot. However, TDFs do have their drawbacks, so understanding these investments before diving in is crucial.
The purpose of TDFs is to adjust asset allocation or investment portfolios as you near retirement, reducing investment risk. This is why TDFs are named after years or target dates. For example, the Fidelity Freedom Index 2045 fund is designed for individuals expected to retire around 2045. As that year approaches, the TDF will adjust its asset allocation. So, if you start investing in a stock-heavy TDF today, by the time you reach your target date, the asset allocation may shift more towards fixed-income investments like bonds, typically lower-risk.
As you get closer to retirement, protecting the assets you’ve accumulated becomes more critical.
However, this doesn’t mean it will completely abandon stocks, as most TDFs also aim for growth.
TDFs have become a staple of 401(k) plans. In fact, according to the Investment Company Institute (ICI), 92% of TDF assets are held in retirement accounts.
Existing regulations also make it easier for plan sponsors to automatically enroll employees in TDFs within their 401(k) plans at a default contribution rate of around 3%.
The Secure 2.0 Act also makes it easier for more employees to join their company’s 401(k) plans. However, even if you don’t have a 401(k), you can still invest in TDFs. Nonetheless, thorough research is crucial when evaluating TDFs in the open market. Plan sponsors are required by law to carefully assess and select funds and investment options within 401(k) plans. Options outside these plans will be up to you, so keeping a close eye on fees or expense ratios is essential.
You may also want to look into the funds TDFs invest in and evaluate them. Make sure you are comfortable with the glide path of the TDF, showing how its asset allocation will change over time as you approach the target date.
Here are some top low-cost TDF options:
– Vanguard Target Retirement 2045 Fund Investor Shares
– Fidelity Freedom Index 2045 Fund Investor Class
– Nuveen Lifecycle Index 2045 Fund Premier Class
– American Funds 2045 Target Date Retirement Fund Class R-5
TDFs can be a solid retirement investment for investors who prefer not to actively manage their portfolios. However, like all securities, TDFs come with their risks.
For instance, upon reaching the target date, you may find the TDF overexposed to fixed-income securities. Or you might find that you still need more time to save and stay in the workforce upon reaching the target date. Nonetheless, TDFs may be best suited for investors who can predict their ideal retirement year and estimate how much they need to comfortably retire.
Imagine you anticipate needing $40,000 annually. If you invest $2,400 per year (3% of an $80,000 salary) for 45 years, you could accumulate $2,214,188.25 by the end of that period. This assumes a 10% return rate, the historical average return rate of the S&P 500 Index, composed of the largest companies in the U.S. It’s also worth noting that many TDFs invest in funds that track the S&P 500 or other indices, also known as index funds, or operate similarly to exchange-traded funds (ETFs).
If you intend to invest in a TDF for retirement, many financial advisors suggest sticking with a single TDF. Most recommend selecting a TDF named after the year you expect to retire. Designed to offer instant diversification, TDFs operate as funds within funds, running their own portfolio, with their asset allocation updated by managers. Therefore, for suitable investors, TDFs provide peace of mind.
However, this doesn’t mean you don’t have other options. You can start building your own investment portfolio using online asset allocation calculators. This helps tailor your portfolio based on your individual goals and circumstances. From there, you can choose a mix of stocks and bonds or ETFs and index funds.
You could also opt for robo-advisors. These algorithm-based platforms recommend diversified investment portfolios based on your specific financial situation and investment goals. Many robo-advisors automatically rebalance your portfolio too. For investors who prefer a hands-off approach, this could be another reliable choice. Robo-advisor platforms also allow you to open Individual Retirement Accounts (IRAs) and Roth IRAs. They offer all the features of these tax-advantaged retirement accounts but with some automation.
TDFs can help investors who prefer not to actively manage their portfolios save for retirement. Their key features include instant diversification, low costs, and automatic asset allocation adjustments for growth and risk reduction as retirement nears. However, upon reaching retirement age, they may be overly invested in conservative fixed-income securities. Therefore, if you are a more aggressive investor and wish to have complete control over your portfolio, you can open IRAs or Roth IRAs and invest in a mix of stocks, bonds, mutual funds, and ETFs. If you are tech-savvy, you can also open these accounts via robo-advisors.