Many 401(k)s offer target date funds as a simple retirement savings solution. But despite their popularity, many people don’t understand how they work. According to a recent Pension Confidence Survey from the Benefits Research Institute (EBRI), one in five workers say they understand target date funds very well.
This leaves a lot of room for improvement. If you want to test your knowledge of term funds, you can start by answering the following four questions.
1. What is a term fund?
A term fund is a mutual fund or exchange-traded fund (ETF) containing assets that become more conservative as a specific year approaches. The target date fund you choose must correspond to the year in which you plan to retire.
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Because investors generally want to become more conservative with their holdings as they approach retirement, these funds offer the advantage of being hands-off investments that automatically adjust your asset allocation over time so that you don’t have to worry about doing it yourself.
2. What is the target date of the fund you are investing in?
If you are already invested in a target date funds, you should know what the target year is for this fund. Most of the time, this is not too difficult to find out because target date funds indicate their target years in their names.
Look this up if you don’t already know the answer, and make sure yours matches the year you plan to retire. If not, you may want to transfer your money to another target maturity fund or other investments that better match your risk tolerance.
3. What is the glide path of the target date fund?
The glide path of a target date fund determines how the fund’s asset mix changes as the target date approaches. Each fund has its own trajectory and mix of assets, with some becoming more conservative faster than others. This can affect how much you earn from the fund and the level of risk you are exposed to.
Some target date funds have “to” trajectories, which reach their most conservative asset mix in the target year. This means that the asset allocation in the fund will not change after this point. Others have “through” glide paths, which only reach their most conservative asset mix after the target date.
It’s up to you to decide which one suits you best. “To” glidepaths shift more quickly to conservative investments, which can reduce your risk of loss. But that often means that you have a large portion of your savings in bonds as the target date approaches, and those don’t generate as much of a return as stocks. Therefore, you may not earn as much on your investments each year as you could with a less conservative portfolio.
4. What are its costs?
All investments have fees, and some target date funds can be quite expensive with expense ratios of 1% or more. It may not seem like much, but it means you give $1 every year for every $100 you have in the fund. If you have $100,000 in the fund at maturity, you lose $1,000 per year with an expense ratio of 1%. High fees eat away at your profits over time, so you want to keep them as low as possible.
Check your target date fund prospectus to find out how much you pay each year. This will likely be an expense ratio – a percentage of your assets – not a fixed amount. Compare this to the expense ratios of some of the other funds available to you through your 401(k) to see how this stacks up and try to keep your fees below 1% of your assets whenever possible.
Answering these questions may not tell you everything you want to know about your target date fund, but it should help you know if it’s right for you and how its asset allocation will change over time. Check the fund from time to time to see how it’s doing and make sure it’s still in line with your retirement goals. If your retirement plans change, you may also want to change your investments.
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