Investors who have been automatically enrolled in their company’s 401(k) plan have a good chance of being placed in a Target Date Fund. TDFs are increasingly popular among 401(k) plans and can be a wise investment choice for participants of all ages. Though one of the benefits of a TDF is the ability for the investments to be on auto-pilot, investors should still understand how this portfolio model works.
A Target Date Fund is a portfolio mixed with stocks, bonds, and cash equivalents, just like any other portfolio of financial assets. Where it begins to differ is in its second characteristic.
A TDF is chosen and structured around the expected date of a participant’s retirement. It then annually resets to include less risk as the date of retirement gets closer.
Since a Target Date Fund is based on the length of time before retirement, a longer time horizon would enable an investor to hold riskier assets (such as a heavier load of stocks with less bonds and cash equivalents). The opposite would be true for a shorter time horizon. The idea is that younger investors have time to rise out the ups and downs of the market, and can therefore take higher risk for higher returns. Those nearing retirement require less risk and more guaranteed returns, therefore the structure of stocks and bonds must change.
Returns are based on market performance and are not guaranteed. The goal is therefore to maximize returns by automatically readjusting a portfolio to experience less volatility as the time horizon shortens.
A TDF is a positive and convenient option for investors who want to be “hands-off” when it comes to their portfolio. Generally, investors in a 401(k) plan either want to structure their portfolio themselves or they do not have the desire or understanding to do anything with it at all. A TDF gives investors the option to keep up-to-date risk preferences while staying on “autopilot” and allowing someone else to make those decisions.
For participants that do not choose a TDF, there can often be confusion with the amount of choices to allocate. Therefore, another strong characteristic of a TDF is that the plan sponsor or adviser takes over the role of managing the funds within the portfolio. The topics that proved challenging to individual investors before- understanding risk tolerance, asset allocation, fund selection, etc.- can now be handled by the plan sponsor who should be competent and knowledgeable on these subjects.
Investors who are overwhelmed with the idea of structuring their own portfolio may prefer a TDF simply because they can now pick just one fund instead of having to choose all the assets within a portfolio. A TDF allows investors to invest in a portfolio with adequate diversification across asset classes that gradually shifts over the years.
Participants should still stay informed and educated about their portfolio and retirement savings, but a Target Date Fund provides a great option for investors who prefer not to rely solely on their own investment intelligence to configure their portfolio. The results of this type of investment are fairly consistent and they often offer lower fees, again making it a prudent choice for many investors.