5 Caveats When Investing in Target-Date Funds

Target-date funds are rapidly gaining popularity as a retirement investing tool. In 2006, the Pension Protection Act approved the use of target-date funds as the default option for 401(k) plans. And many 401(k) plans will automatically enroll you unless you opt out. These two things mean many employees will automatically invest in target-date funds by default.

Investing in target-date funds could help employees to invest more and be better prepared for retirement if they stick with the default plan. However, automatic enrollment doesn't mean investors should ignore their retirement fund. You still need to check a few things to make sure a target-date fund is the right investment for you. Here are five things to review before entrusting your hard-earned dollars to a target-date fund:

Fees. The first thing to check on your target-date funds is the expense ratio. This is how much it will cost you to invest in the fund. Target-date funds can have high expense ratios, with the average being over 1 percent. You might not think 1 percent is a big deal, but the fee will add up to thousands of dollars over many years of investing. If the target-date funds available in your 401(k) plan all have expense ratios over 1 percent, you should consider some different investments with lower fees. As a comparison, the Vanguard Target Retirement 2040 Fund has an expense ratio of 0.19 percent.

Target-date funds usually only invest in the same family fund. The reason why the Vanguard target-date funds have lower fees than other funds is because they invest in Vanguard index funds. These underlying index funds have low fees because they are passively managed. Other target-date funds with underlying actively-managed funds will naturally have higher expense ratios. If you don't like the passive index investing strategy and the target-date funds in your 401(k) plan are from Vanguard, then it's probably best to pass them up.

The asset allocation might not be in line with your risk tolerance. A target-date fund is supposed to be the only fund you need. However, the asset allocation might not be in line with your risk tolerance. This can be a big problem as you near retirement age. For example, the Vanguard Retirement 2020 Fund has 64 percent equity and 36 percent bonds. If you are 55 and are looking to retire in 2020, would you be comfortable with this allocation? If your risk tolerance is low, then you probably would like more of the stability that bonds provide. Check the fund provider's glide path to make sure it is in line with your risk tolerance.

Asset allocation can be difficult as your assets grow. As investors age and increase their investment in accounts other than a 401(k), it will be increasingly difficult to manage the overall asset allocation. The fund companies suggest that investors should put every dollar into their target-date funds, but most investors won't be comfortable with that. It's not easy or prudent to entrust every dollar to just one company.

Target-date funds can be a great introduction to investing for young employees. However, investors still need to do a little homework before letting the fund companies take over. As an investor approaches retirement age and their portfolio grows, it will probably be better to work with a financial adviser to come up with a personalized financial plan.

Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.

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