About half of workers invested in a 401(k) plan rely on target-date funds, and most plans now offer them. But is putting your investments on autopilot the best approach to retirement planning?
It depends on whom you ask.
If you're committed to saving and are knowledgeable about the market, it may be worth comparing these funds to the alternative: building your own portfolio with the offerings available through your company's particular plan.
"If you understand the stock market or you are going to get professional help, you can probably build a better portfolio with [an asset mix] that is more tailored to you if your plan offers good choices," said David Shotwell, a certified financial planner with Shotwell Rutter Baer. "Otherwise, use a target-date fund."
According to data recently released by the Employee Benefit Research Institute, 48 percent of all workers in 401(k) plans were invested in target-date funds at the end of 2014.
These funds, whose assets autopilot their way from growth-oriented (riskier) investments to income-oriented (safer) options as retirement nears, have become a staple in more than 70 percent of 401(k) plans, EBRI data shows.
The research also shows that 65 percent of workers who are offered a target-date option in their 401(k)'s investment lineup actively choose it.
Target-date funds get their names from the year you plan to retire. So a 2040 fund will become more conservative as the year approaches.
But just because fund names share a year doesn't mean their assets are invested similarly. For instance, some funds invest in passive investments, such as index funds; others are invested in actively managed funds; still others are a blend of the two. Some funds start out more aggressively than others; some put the brakes on an aggressive strategy sooner than others.
Additionally, every investor in a particular fund has the same asset allocation, which means the specifics of an individual's life aren't taken into account.
"Target-date funds will get you close to how you should be allocated, but they are based on one data point: when you think you are going to retire," Shotwell said. "That shouldn't be your only consideration."
For instance, your risk tolerance can matter, he said. The better you can stomach zigzags in the market or a prolonged down market, the higher your risk tolerance.
Target-date funds "assume that everyone retiring in, say, 20 years has the same risk tolerance," Shotwell said.
Depending on the fund, its underlying assets could be too heavily concentrated in stocks for an investor with a low risk tolerance.
"If someone gets out of the fund because they're scared [during a stock selloff] and then gets back in, it defeats the purpose of trusting that target-date fund manager to get you where you want to be," Shotwell said.
Conversely, a fund could be far too conservatively invested for a worker with a high risk tolerance and long time horizon until the money is needed.
However, Robert Wander, CFP and owner of Wander Financial Services, cautions that people often get their own risk tolerance wrong even if they think they know it.
"It can be one thing when the market is up and another when the market is down," Wander said.
Also, he pointed out that knowing your risk tolerance and aptly applying it to investing are two different things. For example, Wander has a new client in his mid-60s who had put all of his 401(k) assets in stocks and company shares, but a risk-tolerance evaluation showed he had a very low risk tolerance.
"If people do their own investing, sometimes they might not invest in a way that is congruent with their tolerance," explained Wander.
Cost is a consideration also. Because target-date funds typically are simply a mutual fund comprised of other mutual funds, each underlying fund comes with an expense. And on top of that, the target-date fund might add a fee.
According to data from research firm Morningstar, the average expense ratio across all 611 target-date funds out there — when you include the underlying fund fees — is 0.914 percent.
The average expense ratio across all mutual funds — including both actively and passively managed — stands at 1.193 percent. Index funds as a category come in lower, at 0.864 percent; exchange-traded funds are even lower, at 0.540 percent.
That means that any price comparison between choosing a target-date fund and picking your own funds should include an evaluation of how much of your returns fund fees will eat up.
Shotwell said that if you do want to put together your own portfolio, the ideal 401(k) lineup includes short- and intermediate-term bond funds, a large-cap value fund and a blend fund, good small-cap options, a good broad-based international fund and an emerging markets fund.
Exactly how those investments would be allocated depends largely on your risk tolerance and time horizon.
And you would need to make sure you rebalance the portfolio periodically to maintain an appropriate asset allocation.
Wander said part of the reason he recommends target-date funds is because their autopilot feature lets workers focus solely on the savings side without worrying about the management side of investing.
"My main message to employees is they should focus on one thing only: putting as much money away as they can without [shorting living expenses]," Wander said. "So automate the amount contributed and automate the investment piece."
— By Sarah O'Brien, special to CNBC.com