Using Age-Based Funds In Your 401(k)
If you had a chance to listen to my recent radio interview, Dean Voelker and I talked about strategies for young adults investing in their 401k. I wrote this article for Investopedia. It answers a lot of the age-based or target-date fund questions many young adults may have.
Many people are either so busy they don’t have time to follow their portfolios or they haven’t had the necessary training and education to understand the ins and outs of investing. The good news is that there are funds out there that take all of the guess work out of where to put your money based on your age and risk tolerance. These funds go by several names such as age-based allocation models, age-based funds or target-date funds, but they all are designed to assist the investor by investing in funds based on their age when they plan to retire.
Age-based funds are normally set up as mutual funds. Generally, the funds are set up so that the younger you are, the riskier your fund will be due to the fact that you have time to make up for any large market changes. As you age, the fund becomes less risky in preparation for your pending retirement and dependency on the funds. (For more on this problem, read Bear Market Mauls Target-Date Funds.)Target-risk funds, or lifestyle funds, also assign assets based on risk over time, but instead of being based on age, they are based on whether you consider yourself to be conservative or more aggressive in your investing risk. For this discussion, we will focus on the age-based funds that allocate assets based on a future retirement date.
When looking at lifestyle funds vs. age-based funds, there are some differences. Both funds invest your money in stocks, bonds and cash but lifestyle funds are based more on a person’s risk tolerance, which could stay basically the same throughout his or her lifetime. Age-based funds automatically change as the person ages. With a lifestyle fund, there are no changes unless the person investing in them decides to change into a more or less aggressive fund. This does require action on the part of the investor. With an age-based fund, no action is necessary once the fund is chosen.
Age-based funds have traditionally been thought of as retirement funds. However, there has been a surge of popularity of their use in the 529 plans as well. A 529 plan is a mutual fund set up for college savings. As with retirement funds, the 529 fund changes its risk as the beneficiary of the money ages. One issue that an investor should be aware of is that there may be some duplication of investing in similar funds outside of a 529 non-taxable plan. There may be some need to individualize portfolios in both 401(k) and 529 plans should this be the case. (Learn more about 529 plans in our tutorial on 529 Plans.)
Misconceptions About Age-Based Models
There have been some misconceptions about age-based allocation models. For example, they may not be perfect in terms of anticipating life expectancy past the time of retirement. Should someone retire early or live longer than average, these funds do not account for that. These funds also offer no guarantees that your money will have maximized returns. They are not like a Social Security fund, where a certain dollar return can be expected.
It is also important to remember that all target date funds are not exactly alike. There can be big differences based on which fund family is chosen for the investment. A fund may offer the same year of retirement, but one manager’s idea of a good investment may not be exactly the same as another’s. Remember these are like regular mutual funds in that they carry inherent risks. Just because something is risk-adjusted based on age, doesn’t mean there is no risk.
Their Allocation Mix
As we age, with normal funds, it would require that we move our money around to reduce our risk. The nice thing about age-based funds is that as we age, they are rebalanced for us. This makes investing in these funds much simpler for those who don’t have the time or market knowledge to make adjustments. Instead a fund’s manager deals with adjusting the balance between risk and return. As parts of the portfolio grow and become dominant, the manager can make necessary changes and move funds around to bring the fund back into balance.
As with regular mutual funds, these funds have ratings to give investors an idea of their safety and return. The fund’s Morningstar Risk score assigns ratings stars to these accounts. A fund with the lowest rating would receive one star, while a fund with the highest rating would receive five stars. These ratings are recalculated monthly and should be something an investor monitors to be sure that their fund’s ratings are not changing dramatically. (See our article Morningstar Lights the Way for more information on Morningstar.)
While evaluating funds, remember that because these funds are somewhat new, there may not be the data available on past performance as there would be for funds that have been on the market for many more years. There will still be expense ratios to consider, which will be listed in the fund’s prospectus. Compare funds to see what fees are being charged. The nice thing about these funds, just as with any tax-deferred investing account, is that rebalancing will not have tax consequences until the money is actually removed from the account, ideally in retirement.
Advantages of Investing
Probably the biggest advantage of investing in age-based accounts it the convenience that comes with not having to worry about moving money around. If you are a “set it and forget it” kind of person, they may be the perfect thing for you. Many people prefer to know that an expert is making the decisions for them when it comes to financial choices.
These funds are also a great choice for the beginner investor. A young person just entering the working world may find this is a great way to get their money invested. They can always go back later and move things around once they learn the investing ropes. It may be intimidating for a young investor to pick risky stocks but having the knowledge that there is a pre-set fund that backs some of these types of choices, may alleviate some of their fears.
Age-based funds are highly diversified. They can include stocks, bonds, cash or other types of investments that many people may not fully understand but that may be beneficial. These may include international funds or other such funds that may not be a normal first choice for the uninformed investor. (To learn more, read The Pros And Cons Of Target-Date Funds.)
Disadvantages of Investing in Them
Nothing is ever perfect and even age-based funds have issues. If you like to have control over your money, these funds may not be a good choice for you. The idea of investing in these funds is to not have to control how your money is handled. This lack of control can be considered either an advantage or a disadvantage based on your preference.
Another possible disadvantage could be the lack of age-based choices you are offered through your retirement plan. As with many employer-based 401(k) plans, employees get a limited number of options to chose from. Hopefully, your company has done its research and has optimized the choices available to you. (Want to learn more about employer plans? Take a look at our article, 410(k) And Qualified Plans.)
Many people who invest in these funds may not truly understand that they have inherent risk just as any other 401(k) option has. As these funds are not all the same, some may have more risk involved than others. It’s important to keep in mind that retirement may be a long way off, but even if you retire at 65, you could live another 30 or more years and find that your investment hasn’t yielded enough money to account for such a long life.
The Bottom Line
The bottom line here is to realize that these age-based funds offer some great advantages for those who prefer a hands-off approach. These funds are not for everyone though. Even if you decide to invest in an age-based fund, it is wise to do as much research as you can to compare your available options. Compare fees that are offered and check out what they say about funds offered to you at Morningstar or other similar research sites.
If you’re near or planning to retire soon, be sure to check out other articles like 5 Retirement Questions Everyone Must Answer.
Diane Hamilton’s formal education includes a Bachelor of Science, a Master of Arts and a Doctorate degree in Business Management. She has an Arizona real estate license as well as certifications in the areas of medical representative, Myers-Briggs and emotional intelligence. With more than 25 years of business and management-related experience, her background includes working in many industries, including computers, software, pharmaceuticals, corporate training, mortgage/lending and real estate. She currently teaches business-related subjects for six online universities and is in the process of writing a book on personal finance for young adults. She can be reached through http://www.drdianehamilton.com.via investopedia.com