Target-date funds (TDFs) are like those neat little tools you find in the hardware store that you can put in your pocket. They do a little bit of everything and are compact and easy to use.
There's no denying that TDFs are being embraced by a growing number of retirement investors. More than 70% of 401(k) plans have them, according to the Employee Benefit Research Institute (EBRI), accounting for nearly one out of five dollars invested in these plans.
Who likes TDFs the most? Employees in their 20s. Some 60% of those surveyed in this age range owned them. They're convenient one-stop shopping for those who don't want to have a hands-on retirement portfolio.
But like most tools, TDFs can be dangerous if used incorrectly. You could get poked at the wrong time when saving for retirement. Here's what you need to know:
Is the Mix Right? TDFs put your retirement investing on auto-pilot by adjusting the mix of stocks and bonds over time. By the time you hit your expected retirement year or "target date," TDFs will have a smaller percentage of stocks and a larger portion in bonds and cash. That's designed to insulate you from market risk the closer you get to retirement.
What about inflation? You may want more in stocks, particularly if you plan to work later. Remember that stock returns generally beat inflation over time. Most bonds will never keep up with the cost of living.
Are You Taking a Balanced Approach? Again, you need to ask questions about how the "glide path" or ratio of stocks and bonds over time covers all the bases. Remember that most people need a diversified approach.
A truly balanced TDF invests in stocks and bonds from across the world. That means emerging markets and real estate investment trusts, stocks that invest in real estate.
Is the Risk Profile Right For You? A lot of TDF investors were burned when their portfolios dropped up to 40% in the 2008 crash. If you don't have time to recover, that could be catastrophic for your retirement portfolio.
An easy way to vet risk is to look at how much your TDF funds declined in the bad years. I would start with 2008-2009 and 2011. If you don't like what you see, you may be better off outside of a TDF with a plain-vanilla balanced fund.
If you want a more detailed look at how a TDF performs in a sell-off, ask about its "drawdown." This is how much it can lose in a downturn.
Do You Understand Your Alternatives? Of course, you should have a number of options in your 401(k). TDFs may not be the right choice for you. Ask your plan administrator how you can invest in other funds. You may be better off outside of a TDF.
If you venture outside of the TDF umbrella, though, don't try to time the market. You’re not smarter than professional investors and will lose money. Keep a gut-friendly balance in 60% stocks and 40% bonds. That's the middle road for most investors, although feel free to tweak it.