A growing number of retirement savers who consistently participate in 401(k) plans are putting their money in target-date funds. Target-date funds invest in a mix of stocks, bonds and other assets based on your age and the date that you expect to retire. They rebalance over time, becoming less focused on growth (and stocks) and more focused on income (and bonds), as you get closer to your "target" retirement date.
"They can make a lot of sense for more hands-off investors," said Morningstar analyst Janet Yang. "If an investor isn't willing or able to do the research to pick large-cap, small-cap, international or fixed income funds and then also combine them into a sensible portfolio and rebalance at least annually, then target-date funds, which combine all of the above into a single holding, might be a good option."
Total assets in target-date funds stood at $690 billion at the end of June, according to Morningstar, representing a third of new assets among the leading asset management firms. Those funds are the top choice for many 401(k) investors. One third of retirement savers with target-date funds held all of their 401(k) account in such funds at the end of 2012, according to a new report from the Employee Benefit Research Institute.
But while they are a popular investment in many retirement plans, they may not be right for everyone.
Here are a few considerations to make in order to ensure that the target-date fund in your 401(k) doesn't retire before you do:
- Asset allocations can shift unexpectedly. Target-date funds may be attractive because of their set-it-and-forget-it features, but that doesn't mean that investors can take a pass on all research. According to Morningstar, the average portfolio designed for people in their early 30s has 90 percent of its assets in stocks and the rest in fixed income. The equity allocation falls to 35 percent for savers in their 70s.
But individual funds can shift those allocations as they deem necessary. Target-date funds aren't uniform offerings, and there's a huge range of allocations between different target-date funds. Among 2015 funds that are meant for those on the brink of or just in retirement, Morningstar found a 30 percentage point difference between funds with the lowest and highest equity allocations.
- Asset mix does not consider your goals or tolerance for risk. "Target-date funds are created for the average investor, and there are many factors—savings rates, salary levels, family situation—which can make an individual investor look very different from the average," Yang said.
It is very important you consider your stomach for risk and that your goals—in terms of when you plan to retire or need the money—align with the target date. Then you can determine whether you should invest in a target-date fund with more aggressive characteristics, or if you're better off in a fund that, while it may lag in up markets, will better protect capital in down markets.
- "Target date" may not be your "end point." Make sure your fund's "target date" aligns with your investment horizon. Funds can be misused if investors don't understand what it really means to have a "2020" fund, for example. The year 2020 is the year that you'd plan to retire—not when you want to retire, though you know you'll really have to work longer.
"Some managers run their target-date funds as if it is a sort of end point—to the target date—while others manage their funds with time horizons that go well beyond or through the target date," Yang said. Make sure you pick the right fund and the right year that aligns with your goals and how much risk you can handle.
Bottom line: You want to make sure you have a mix of stocks and bonds that allows for enough growth so that your 401(k) does not retire before you do.
—By CNBC's Sharon Epperson