Congratulations, you are eligible to participate in your employer’s retirement plan! Your HR department sends you the overwhelming employee benefit packet that hardly any employee reads, but you are different – you are dedicated to understanding and getting what’s rightfully yours! If your employer provides a defined contribution plan like a 401(k) or 403(b), you get to select a percentage of your gross pay to withhold and invest each pay period. You hopefully elect to contribute at least enough to get the full employer match (if available), and now it’s time to choose how to invest these tax-deferred dollars. You may feel overwhelmed by the dozens of investment options or tempted to ask a colleague “hey, what did you choose?,” but thankfully there are resources available to help you understand this personal decision.
There are usually three types of investment options to mix and match within a retirement plan:
Target date funds are the ‘chauffeured’ approach to investing. Like a chauffeur who drives you to your intended destination using their chosen route, this fund is designed to ‘arrive’ at your desired retirement age (traditionally age 65). Unlike risk tolerance, risk capacity is determined by your investment time horizon, meaning ‘how long until you’ll need the money,” and the allocation between stocks and bonds is based on historical investment returns. This ‘set it and forget it’ approach can be helpful for investors who do not have the time, temperament, or talent to actively manage retirement accounts throughout the years.
A target date fund is like a basket of mutual funds, invested in thousands of diversified stocks and bonds across U.S. and international sectors. As previously mentioned, you could choose multiple funds from your custom lineup, but target date funds are intended to make your selection simple – choose a single target retirement year and focus your effort on other interests. The target retirement year is identified in the fund’s name; a 2060 fund could be appropriate for someone with a 40-year investment time horizon. The underlying funds are professionally managed by the fund company and rebalanced over time, shifting to fewer stocks and more bonds the closer you get to retirement. Here is a visual representation of how target date funds are allocated to more equity (stock) in the early accumulation years, then shift to more fixed income (bonds and cash) as retirement nears. I analyzed four fund companies for this example, but there are dozens more. These allocations are subject to change, and the data is as of August 31, 2020.
As shown above, the equity allocation of these funds stays above 80% until about 20 years before retirement, then de-risks to a conservatively balanced 40% to 50% equity allocation over the next two decades. You may have noticed that the equity positions level out at retirement age instead of falling to 0%; this indicates that maintaining equity growth in a retirement portfolio is essential to make the savings last up to 30 years or beyond. “Own your age in bonds” is a common investment rule of thumb that is not appropriate for most investors.
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