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What Is a Target-Date Fund?

- Erwin Matuschat—Getty Images/EyeEm
Erwin Matuschat—Getty Images/EyeEm

Q.: My employer automatically enrolled me in the company 401(k) retirement plan and put 100% of my money into a target-date fund. Is this safe? What exactly is it?

A.: Not to worry. These days most large employers auto-enroll new employees (and sometimes current workers) into their 401(k) plans to get people started on saving for later life. Your contributions are automatically directed into a default investment, which is typically a target-date fund. You can always opt out, or choose a different investment. But you are probably better off staying put, since a target-date fund is great option, especially for investors just starting out.

One key benefit of a target-date fund is simplicity. Within a single fund, you get instant diversification across a wide range of asset classes, which typically include U.S. and foreign stocks, REITs (real estate investment trusts), government bonds, and corporate bonds. The fund’s asset mix gradually shifts over the years to become more conservative by the time you retire. That's the "target date" part. If you're 30 years old today, you might be placed in a 2050 fund, since that year is close to when you will turn 65, the traditional retirement age. (A fund company will typically offer a series of target funds in five-year increments.)

The changing asset mix, also called a glide path, means that a target-date fund's portfolio will look quite different depending on your age. Workers in their 20s and early 30s might hold a hefty 80% to 90% allocation to stocks, which offer the potential for higher returns but more risk. The idea is that younger investors have time to ride out market downturns, but—fair warning—those losses can be steep at times. As you approach retirement, when the focus shifts to preserving your savings, the fund dials back on stocks and revs up fixed-income, generally giving you a mix that's closer to 50% stocks and 50% bonds.

Target-date funds have proven to be an effective way to invest for retirement over the long run, especially when compared with the results of do-it-yourself investors. Over the five years ended in 2015, investors who held a single target-date fund earned average returns of 7.6% a year vs. 7.2% % for DIY-ers who picked and chose among the items on their plans' investment menus, data from Vanguard show. The do-it-yourselfers also had a much wider range of returns, while target-date investors had more consistent results.

Low fees are helping to boost these returns. The three major fund companies with the largest share of the target-fund market—Vanguard, Fidelity and T. Rowe Price—offer funds that carry below-average costs. T. Rowe's line-up of actively managed funds charge an average 0.74%, which is much less than the average 1.5% for the typical actively managed stock fund, according to Morningstar. Similarly, Fidelity's Freedom series costs about 0.75%. Funds that track a market index are cheaper than those that rely on human managers to select securities: Vanguard's indexed target-fund offerings have fees of about 0.15%.

"You may pay even less if your plan provider offers institutionally priced target-date funds," says Jeff Holt, associate director of research at Morningstar. Such funds may have annual fees that are only a few hundredths of a percent.

Still, you can’t leave your 401(k) entirely on auto-pilot, even with a target-date fund. Review your plan at least once a year and assess whether a target-date fund is still right for you. If you feel nervous about market drops, you may want to choose a target fund with a tamer asset mix; you can do that by switching to a fund for people who are five or even 10 years older than you. Or if you plan to work longer than age 65, you may prefer one with a more distant retirement date.

As your finances become more complex, you may want to choose your own mix of funds to better manage your overall asset allocation. Just don’t make the mistake of adding a bunch of other funds to the target-date fund in your 401(k), since that defeats the purposes of a standalone fund—and it also tends to reduce returns, research by Financial Engines has found.

Whatever 401(k) investment you choose, it won't help you reach your goals unless you're saving enough of your pay too. Most plans with auto enrollment set your contribution level at a low 3% or 4% rate. Sure, that seems like a big bite from your check if you're just starting out. But it’s not enough to build the retirement portfolio you will need. So make sure you’re saving enough to get a full matching contribution from your employer, which might require you to set aside 6% of pay each year. Then, ratchet up your contribution rate by 1% of pay or more a year till you’re putting away 10% to 15% of pay. That way, you’ll have a much better shot at being able to live your retirement dreams.

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