Here's What Happens When You Invest in a Target Date Fund

When you save for retirement in an IRA, you generally get the option to hand-pick individual stocks for your portfolio. But 401(k) plans generally do not let you buy stocks individually. Instead, you're usually limited to different funds to invest in.

You'll commonly find mutual funds as an available option in your 401(k), as well as passively managed index funds. And there's a very strong chance your 401(k) will also let you invest your money in a target date fund.

In fact, Vanguard says that 98% of 401(k) plans use a target date fund as their default savings option. This means that if you don't select specific investments for your 401(k), you'll be put into a target date fund automatically.

A target date fund could be a good choice for your 401(k), especially if you're someone who doesn't want to have to put a lot of thought into investing for retirement. But you should also know that these funds have their drawbacks.

How does a target date fund work?

A target date fund is set up to help you save for a specific milestone, like retirement. What'll happen is that your fund will automatically rebalance your portfolio over time so you're taking on the optimal amount of risk given your age.

As an example, a target date fund will generally put you into more aggressive investments, like stocks, when you're younger. Stocks can be very volatile and there's a notable degree of risk you take on when you own them. But they tend to generate solid returns to make up for that, and you need those strong returns for your money to grow.

Then, what'll generally happen with a target date fund is that you'll be shifted into safer investments, like bonds, as retirement gets closer. This way, you're not taking on undue risk.

Is it smart to invest in a target date fund?

A target date fund is something you can truly set and forget. So if that's the approach to investing you'd like to take, then a target date fund could be a good bet for you.

That said, there are a few drawbacks to choosing a target date fund for your 401(k). First of all, these plans tend to err on the side of being conservative. That's a good thing if you're very risk-averse. But it also means that you might end up with lower returns than you'd get from a mutual fund or index fund. And lower returns mean less money for retirement.

Also, you'll generally face investment fees for each of the options your 401(k) plan offers. But the fees charged by target date funds can be high. And you might pay a lot more to put your money into a target date fund than into a passively managed index fund.

All told, target date funds tend to be a popular choice for 401(k) plans, and it's easy to see why the idea of putting your savings into one is appealing. But you may want to explore other options before settling for a target date fund.