If you have a workplace 401(k), there’s a good chance your account has a default investment that your money will be put into unless you specifically make a change to your investment strategy.
In most 401(k)s, that default investment is a target date fund. In fact, Fidelity shows a whopping 98% of all employers allow workers to invest their 401(k) money in a target date fund — and 92% of 401(k) accounts use them as the default option.
But is this the best choice for your retirement funds?
What is a target date fund?
A target date fund is an investment option that’s designed to simplify the process of asset allocation.
See, your money should be allocated into a mix of different investments, including stocks and bonds. And that mix should change over time based on how close you are to retirement. As you get older, you’ll want less equity exposure because you won’t have time to wait out market downturns and could be forced to sell stocks at a loss if you end up needing to begin withdrawing your funds before a recovery.
Target date funds take the work out of assessing your risk tolerance, choosing an appropriate asset mix, and rebalancing your portfolio as you age. When you invest in a target date fund, you simply specify the date you’ll need access to your investments. So, if you plan to retire in 2050, you might choose a Retirement 2050 fund.
Your money is then pooled with other investors’ and invested in an asset mix that’s tailor-made to be appropriate for your retirement timeline. Target date funds can be actively managed, which means an investment manager manually picks what your money is invested in. Or they can be passively managed, so the selection of investments is chosen automatically via algorithms.
Should you use a target date fund for your 401(k) investments?
The big benefit of target date funds is their simplicity.
You make your decision once about what fund to invest in, and you never have to think about it again. If your 401(k) is one of the majority of accounts that Fidelity found defaults to investing in a target date fund, you don’t even actually have to make any real decision at all other than sticking with the status quo.
But there are some downsides. The biggest is that target date funds often come with high fees, which can eat into your returns. When you’re investing for retirement over decades, paying even a small amount in extra fees can leave you with tens of thousands less by the time you reach retirement age. The other downside is that you give up control over your investments — and the investment mix the target date fund chooses for you may be more or less conservative than your preferences would be.
Ultimately, if you have the knowledge to pick a mix of different investments that’s designed for your personal risk tolerance and that have low fees, you will do better than with a target date fund. But if you aren’t comfortable taking a few minutes each year to build or rebalance your portfolio, a target date fund could indeed be the best choice for you.