If you're choosing among the retirement funds on your 401(k) menu, you may have noticed something called a target-date fund on the list.
Target-date funds typically consist of a mix of stocks, bonds and other investments that determine their risk based on when you want to retire.
The funds are a popular choice among workers. Fifty-nine percent who have access to a 401(k) or other employer-sponsored plan said they use an automatic allocation strategy to save, according to research released in June by the Transamerica Center for Retirement Studies. In contrast, 43 percent use a do-it-yourself approach.
Aaron Pottichen, senior vice president at Alliant Retirement Services, compares using target-date funds to helping his son learn how to ride a bike. The choices are to either let him figure it out on his own, which could make him frustrated and decide never to do it again, or put training wheels on the bike and gradually help him learn to ride.
Target-date funds offer a similar gradual approach, Pottichen said.
"A target-date fund kind of has training wheels to help people make sure they stay upright and are on the right path," Pottichen said. "That's how they're beneficial."
Despite the funds' simplicity, investors often make the same errors.
When picking from the funds on your retirement plan menu, it may be tempting to add in or international funds alongside a target-date strategy.
But using other kinds of strategies alongside a target-date fund is one of the most common errors people make, according to Pottichen.
"The best way to use these target-date funds is to go 100 percent in one of them or not," Pottichen said.
That is because target-date funds are crafted with specific allocations in mind. Add more funds to the mix, and you could be overexposed in one area.
Likewise, you do not want to use more than one target-date fund.
"We came across one person who had money in every one of the target-date funds, evenly distributed," Pottichen said. "It didn't make any sense."
That is because each retirement fund is geared toward a certain year. So if you think you want to retire in 40, 30, 20 years or somewhere in between, there is a fund for you. But invest in more than one fund, and you are confusing your goals — and undermining the benefits of the funds.
You also want to make sure that the particular fund you pick matches when you really think you will retire.
Two 35-year-olds may not want to invest in the same target-date fund, Pottichen said. If one wants to retire at 60 and the other wants to work as long as possible, that could mean the difference between a 2040 fund for one and a 2060 fund for the other.
"You need to make sure the allocation is right for you," Pottichen said. "Do you have a plan? And then that plan dictates how you're invested."
You want to make sure that the target-date funds you're offered do not have high fees that outweigh their benefits.
Look at your fee disclosure statement, Pottichen said, and then talk to the outside vendor to make sure there are no additional hidden costs.
If the target-date strategy is expensive, you may want to select other funds, provided that there is a diversified menu of choices, Pottichen said.