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4 Questions to Ask Before Investing in a Target-Date Fund for Retirement

These set-it-and-forget it funds and similar 401(k) options can make investing simple, but you need to know how to size them up


Target-date funds, which are offered as mutual funds and as investment choices in some 401(k) retirement plans, boast a simple proposition: Choose the year when you expect to need the money – typically, when you think you’ll retire – invest some cash, and let the fund manager allocate the money among stocks and bonds so you’ll be in good shape when your target date arrives.
 
Some people call target-date funds “set-it-and-forget-it” funds, because their fund managers do all the investment decision-making. Typically, target-date funds invest mostly in stocks when you’re young and gradually shift toward more conservative bonds as you age. Many 401(k) plans automatically invest employee contributions in target-date funds unless the employees select a different option. "Target-date funds make things very simple for the average investor," says Edward Gjertsen II, a certified financial planner at Mack Investment Securities in Glenview, Ill.
 
The trouble is, some target-date funds have been disappointing, if not downright depressing, for investors. During the 2008 market crash, many of the funds with target retirement dates for 2010 were heavily invested in stocks, so investors who thought they were protected against market drops lost a quarter of their retirement savings, on average.  (As a result, some mutual fund companies have altered their funds to lower their exposure to the stock market.)
 
Target-date funds didn’t fare much better in 2011. Morningstar, the fund research company, found that the average fund with a 2015 target date fell 0.4 percent in 2011. By comparison, the S&P 500 (an index of 500 stocks that is considered the barometer of the overall market) was up last year, with a total return of 2.1 percent.
 
If you’re considering investing in a target-date mutual fund or a target-date account in your 401(k), be sure you can answer these questions:
 

What’s the fund’s glide path? A target-date fund’s “glide path” is the way the fund manager will change the mix of assets as its target date looms closer. For instance, a fund managed for a target 40 years into the future might start out mostly in stocks, then shift more heavily into conservative bonds as 2052 nears to help avoid the chance of a loss when investors need the money. Some target-date fund managers take more risk in the stock market early on, while others take more risk in later years. What’s right for you depends on your comfort level.

The prospectus and marketing materials for the fund or 401(k) account should discuss the glide path. To see how a fund’s glide path works in practice, go to the fund company’s website to see the current holdings of a target-date fund operated by the same company for people closer to retirement than you are.  Many target-date funds in 401(k) plans are very similar to mutual funds sold from the same company, so the glide path for a fund will typically be much like the one its investment firm offers in 401(k) plans.
 
Is the fund managed to retirement or through retirement? Some target-date funds are managed with the assumption that you’ll take out all your money on a given day in your fund’s target year and immediately roll over the cash into another investment. But other funds assume you’ll hold onto the fund throughout your retirement years and will just start taking periodic withdrawals in the year noted in the fund’s name.
 
The difference between “to” and “through” can have a dramatic effect on how the fund invests. Josh Charlson, senior mutual fund analyst at Morningstar, says that fund managers who plan to keep investing through your retirement might hold 50 percent of their money in stocks in the target-date year. “They are looking toward a retirement that is going to stretch another 20 or 30 years,” he says, adding that putting the fund in safe assets “isn’t going to generate the capital growth needed." A target-date fund’s prospectus will spell out the fund’s time horizon for investing.
 
What does the target-date fund cost to invest? The key here is to learn the fund’s “expense ratio” – the percentage of fund assets that go to compensating its investment firm. On average, target-date funds have higher expense ratios than traditional mutual funds. All else being equal, higher expenses mean lower returns. According to the Financial Security Project at Boston College, the average target-date fund has a 0.7 percent expense ratio, but some of the funds charge as little as 0.2 percent and others as much as 1.0 percent. “People should be aware if there are higher fees involved in target-date funds instead of investing elsewhere by themselves,” says Catherine Cooper, a certified financial planner and chartered financial analyst at Azure Financial Advisors in Glencoe, Ill.

You can see a target-date fund’s expense ratio in its prospectus and can then compare it with ones on stock funds and bond funds you might buy instead.
 

Does my 401(k) offer a balanced fund that’s rated higher than the target-date fund? Morningstar’s Charlson says that while target-date funds may be a good idea for many investors, not all target-date funds are good ones. If you are looking for a target-date fund on your own, not for your 401(k), compare funds from different companies for their performance, fees and glide paths. If your 401(k) plan has only one target-date option, Charlson suggests going to morningstar.com and comparing the Morningstar rating for the target-date mutual fund from the same investment firm and a balanced fund from the investment firm offering a balanced fund in your 401(k). (A balanced fund is a mutual fund that holds stocks and bonds.) If the balanced fund is rated higher than the target-date fund, it may make sense to stick with a balanced fund in your 401(k) and skip the target-date option.

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