Evaluating your 401(k) plan can be a brutal and daunting process. It may leave you with many questions about the investments available to you and how to best manage your account. It may even deter some from participating in the plan altogether. Fortunately, there are ways to help simplify the process. The first step? Understanding one of the most commonly used investment options within 401(k) plans: the target-date fund, or TDF.
Almost all employers that offer a 401(k) plan include TDFs in their plan lineups, since these vehicles provide a convenient, easy-to-use, low-maintenance choice for plan participants.
TDFs are professionally managed investment portfolios named with a target year (i.e., the expected year of retirement). The funds automatically adjust their allocation (a mixture of stocks and bonds) as the investor gets closer to retirement. For example, a target date 2030 fund is designed to be the appropriate allocation of stocks and bonds for someone who plans to retire in 2030. Most likely, this fund would invest more heavily in bonds and less in stocks than, say, a target date 2050 fund. In the latter case, the retirement age is 30 years away; therefore, the fund would have a greater allocation in stocks to start, as stocks are usually a more aggressive investment option.
TDFs are designed to be a one-stop shopping approach. Instead of building a 401(k) account using a TDF and other mutual funds, you can choose one TDF—typically with a target date closest to your anticipated retirement—and get access to a full mix of investments grouped together in a single portfolio. The TDF will update automatically to become more conservative (i.e., invest more in bonds and less in stocks) as you approach retirement. This means with one investment you have access to a diversified portfolio that protects your money from various risks while still generating a market-like return.
Of course, it can be difficult to predict the exact year you plan to retire, and these investments are offered in five-year increments. As such, you may want to select a year a bit before your expected retirement date (a slightly more conservative choice) or a year after your expected retirement (a slightly more aggressive portfolio).
No investment is without risk. Asset allocation risk in particular may be elevated with TDFs. Suppose your fund currently has a 60/40 equities-to-fixed income ratio (which, in most cases, is considered a balanced portfolio). In theory, that fixed income allocation should provide a buffer during a market downturn. But some TDFs actually invest more heavily in high-yield bonds than you might expect, and high-yield bonds tend to follow stock market performance, which means your TDF may lose more money than anticipated.
It's also important to consider whether your TDF uses a "to" or "through" strategy. "To" funds are designed to get you to your target retirement date; if you continue to hold the fund, no additional allocation adjustments will be made, which means you could lose some upside potential. "Through" funds continue to reallocate the portfolio after reaching the target date, which means greater upside potential but also greater risk.
As Brad always says, it's important to look beneath the hood, so you know exactly what you own.
In a nutshell, investing 100 percent of your allocation in one TDF can be a highly effective, yet low-maintenance, 401(k) plan investment. Just be sure to do your due diligence before picking your fund.