It’s a strategy that requires zero effort on your part. But that’s not automatically a good thing.
You can’t afford to leave the money in your 401(k) plan sitting in cash. If you do, you’re unlikely to grow your savings enough to outpace inflation. And that could lead to a shortfall of funds in retirement.
That’s why investing your 401(k) plan is a much better bet. And while you have a number of options to choose from, for some people, target date funds are an easy solution.
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What a target date fund does is adjust your risk profile based on your investing timeline. If you’re 30 years away from retirement, you’ll generally start off with more aggressive investments that carry more risk. Then, as you get closer to retirement, your investment mix will be adjusted to get more conservative.
Putting your 401(k) into a target date fund could be your easiest ticket to building wealth for the future. But it may not be your most efficient.
The problem with target date funds
Target date funds are truly a “set it and forget it” type of investment. They’re perfect for people who want to take a hands-off approach to growing their nest eggs. And to be clear, there’s nothing wrong with that.
In fact, many 401(k) plans are set to default to target date funds so that if you don’t actively choose investments, your money will land in one automatically. That highlights how effective they are on a broad level.
But before you decide to keep your 401(k) in a target date fund, you should know about their drawbacks. For one thing, target date funds tend to err on the side of investing conservatively, which could leave you with a smaller 401(k) balance by the time your retirement rolls around.
Target date funds are also known to charge high fees, known as expense ratios, that have the potential to eat away at your returns over time. That combination could cause you to fall short of your savings goals.
Index funds may be a better investment
While many people choose target date funds for their 401(k) plans, you may want to consider putting your long-term savings into a broad market index fund, like an S&P 500 index fund, instead. The upside is that you can still take a “set it and forget it” approach, more or less, since you’re not investing in stocks individually. Rather, you’re buying into a broad index that encompasses the 500 largest publicly traded companies out there.
With an S&P 500 index fund, you don’t have to worry about investing too conservatively. And because index funds are passively managed — all they really do is aim to match the perform of the indexes they’re associated with — you may be looking at considerably lower fees than what you’d pay in a target date fund.
There’s nothing wrong with choosing to keep your 401(k) in a target date fund. But given that your money might land in a target date fund without you even realizing it, it’s important to know what pros and cons you’re looking at.
