If you participate in a workplace retirement plan (401(k), 403(b) or similar), there is a very strong possibility that you are invested in a target date fund (TDF). In 2020, 50% of 401(k) accounts were held exclusively in target date funds, and 75% of accounts contained at least one TDF. But do you know exactly how they work?
The “how” can be answered by starting with the “why”: Why have TDFs exploded in popularity in recent years? In 2006, the law that governs how workplace retirement accounts are managed was adjusted to allow employers to more easily enroll new hires automatically into a retirement plan. Further, TDFs were identified as a qualified default investment alternative for these automatic enrollments. Such an investment, per the government, “must be diversified so as to minimize the risk of large losses.”
TDFs are a simple way to invest geared to each investor’s retirement time frame. When you are placed in a TDF automatically, the TDF you get is one that is based on the assumption that you will retire in your mid-60s. The TDF will contain a mix of investment types (stocks and bonds) that are weighted more heavily towards stocks when you are young, and each year becomes gradually more conservative i.e. weighted increasingly towards bonds. This is called the glide path. And because it happens automatically, you as the investor need not lift a finger. (The TDF will also rebalance itself automatically to account for changes in market values between different assets in the fund.)
A typical TDF might look like this:
- For a person expected to retire 30 years from now, 90% stocks and 10% bonds.
- For a person expected to retire 10 years from now, 67% stocks and 33% bonds.
TDFs gained favor because the government not only wants you to save for your retirement (hence the tax advantage), but they want you to invest appropriately for retirement based on your capacity to absorb investment risk. Not too hot, but also not too cold. When you are younger, you have the ability to ride out changes in the market because you do not need your funds any time soon. As you get closer to retirement, a wildly gyrating portfolio could be a disaster.
Don’t undo the good work that your TDF is doing for you by adding on additional funds within your retirement plan. The whole premise of a TDF is that it is calibrated constantly to your investment goal. When you split your 401(k) investment between a TDF and another fund, you throw off that careful calibration. Now, looking at your total portfolio holistically, it is no longer balanced to your stated retirement objective.
With that said, do not invest blindly. The selection of a TDF based just on your expected retirement date (your risk capacity) assumes that you have an average person’s risk tolerance — the emotional wherewithal to withstand changes in market values without over-reacting. That may not describe you at all. For example, although you are set to retire in 20 years, you may feel uncomfortable with your “assigned” TDF and prefer to invest based on a shorter time horizon, such as 10 or 15 years. Alternatively, you may be happy to take on more investment risk than “average.” In that case, you might choose a TDF that is geared to a 25 or 30 year time horizon.
TDFs may not be for everyone. Some people simply prefer to take a more hands-on approach to their investments, either on their own or with an investment professional for guidance. And this preference may change over time as you become more comfortable with investing. (That said, many seasoned investors will still stick with a TDF.) Ultimately, the most important determinant of successful investing for retirement is simply that you do it.
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