In recent years, companies who offer 401(k)s to their employees have continuously expanded their services. Implementing programs that automatically increase contributions, offering access to money managers to handle employee assets and more. One feature that is increasingly seen in these plans is the offering of target-date mutual funds. So what are they, and how do you know whether they're an appropriate investment for your retirement account?
If you were here for our video on stocks, bonds, and mutual funds, you'll recall that a mutual fund is a basket of securities that can have stocks, bonds and other types of investments inside. There are some mutual funds that have a particular risk tolerance in mind, such as moderate or moderately aggressive. Others may focus on investments in a certain market sector, be it technology stocks or investments in the healthcare industry. Another type, which are often found in 401(k)s and are most relevant to our discussion today, are target date funds.
What Are Target Date Funds?
Target date funds, which you might also see called life cycle funds, are mutual funds whose principal concern is a specific date in the future. With target date funds, the target year will be in the mutual fund's name so investors will know how to differentiate one from another. For example, if you have a target date fund whose name is Sample Mutual Fund 2055, the 2055 stands for the year 2055. Investors who choose this fund should be those who don't need to withdraw their money - or in this case - retire, until a year close to 2055.
How Do They Work?
Target Date Funds use their target year to determine how conservatively or aggressively they will invest. In our Sample Mutual Fund 2055 example, the year 2055 is a pretty long ways off. As a result, you can expect this mutual fund to be invested fairly aggressively, as they have over 30 years before their investors need the funds. But here is great thing about target date funds: the closer they get to their target year, the more conservative they become. In the year 2018, Sample Mutual Fund 2055 might be made up of 90% stocks and 10% bonds, which is fairly aggressive. Twenty years later, in the year 2038, they now only have 17 years left until the target year, and the mix of investments in our fund might now be 60% stocks and 40% bonds. Fifteen years later, the fund is two years away from its target date, and could have an investment mix of 40% stocks and 60% bonds, considerably more conservative than it was in 2018. This is an important feature for two reasons:
- Ease of investment choice: being able to choose your investment based off of the year you want to retire hopefully prevents employees from feeling like they have to become investment gurus to make a choice in their 401(k). They simply find the mutual fund whose target year is closest to their desired retirement date, and plug it in.
- Reduces the need to change investments over time: before the introduction of target date funds within 401(k)s, investors might have picked an investment at age 25 that was appropriate at that time, but by the time they reached 60 could be more aggressive than they needed. These investors would be forced to change their investments, which can be confusing. But by investing more conservatively the closer you get to your retirement, target date funds hope to offer employees an investment choice that they won't have to repeatedly change.
How Do I Choose A Target Date Fund?
For some investors, choosing a target date fund is as simple as finding the fund whose target year is as close to when you want to retire as possible. However, others might find the fund close to their retirement year and find that the asset allocation (i.e. the mix of stocks and bonds) is more aggressive or conservative than they would like. Should this be the case for you, check out the allocation of the other funds provided by your employer and find the one that fits what you're looking for, even if the target year doesn't seem to be relevant.
That's it! Hopefully this demystifies some of the options you see each year when looking at your 401(k). Stay tuned for more articles about retirement planning, and as always, if you have a topic you want us to cover - either on our website or our YouTube page, you can submit them by filling out the questionnaire on or blog. See you next time!