Target-Date Funds Might Not Be Right for You

Ryan Ermey, Associate Editor, Kiplinger's Personal Finance
Branching out and investing in a mix of funds can give you a portfolio that's cheaper, better diversified and more in line with your needs.

The other night at dinner, the topic of my roommate's retirement account came up. He told me that he had an account (good start) and knew roughly how much he contributed to it (also good). But he didn't know exactly what he was, um, invested in. I suggested that he might be in a target-date mutual fund, and yes, he remembered, that was it.

See Also: Target-Date Retirement Funds: 5 Top Fund Families

It was an educated guess. Half of 401(k) plan participants invest at least some of their assets in a target-date fund, says the Investment Company Institute. It's a familiar story among my age group: "It was the default option when I signed up, and I haven't looked at it since," the story goes.

That's not necessarily a bad thing. A target-date fund is meant to be a set-it-and-forget-it investment. The fund company manages your investments for you, holding a mix of assets that grows more conservative as you approach the year you plan to retire. That might be ideal for my roommate and a lot of other people, too. But those who are becoming savvier investors might consider branching out. By investing in a mix of funds, either in your plan or outside of it, you could end up with a portfolio that's cheaper, better diversified and more in line with your needs. 

The right mix. Even if you've learned a bit about investing since opening your 401(k), you may not want to ditch the target-date fund altogether. Rather, see how it fits with your overall investing plan and your personal preferences. The mix in a target-date fund depends on your time horizon. The farther you are from retirement, the more aggressively you can invest because you have time to recover from market dips. But a major shortcoming of target-date funds is their inability to factor in your personal tolerance for risk, says Brian Schmehil, a certified financial planner in Chicago. "During the financial crisis, this was problematic for investors who had a conservative risk tolerance but a long investment horizon," he says.

He suggests taking an online risk-tolerance test to find your personalized allocation target (search "Vanguard Investor Questionnaire" to find one we like). Compare that with the mix in your target-date fund. If they don't line up, adding another fund or two from your plan's roster can ratchet up your exposure to stocks (if you're more aggressive) or bonds (if you're more cautious).

You may also want to add funds to diversify your stock holdings. Morningstar personal finance director Christine Benz suggests modeling your stock portfolio after the global stock market, investing the core of your stock holdings--some 55%--in U.S. stocks and the rest in international markets. Among your foreign holdings, devote 15% to 20% to emerging markets (see Opening Shot) and put the rest in developed markets. You'll also want a mix of growth-oriented and bargain-priced stocks, as well as companies of different sizes.

Pay attention to fund costs. Over the course of your investing lifetime, paying even half a percentage point more in fees can erode thousands of dollars from the value of your investments. The average actively managed stock fund charges 1.1% of assets in expenses; the average index fund, 0.6%.

Look at past performance, but view a fund's one-, three-, five- and 10-year returns skeptically; these numbers can be skewed by a huge uptick or downswing in any single year. Rather, a fund should stack up favorably most years against peers and its benchmark.

If your 401(k) has few attractive options beyond your target-date fund or doesn't offer an investment you want--say, an emerging-markets fund--consider investing through an IRA, but only after investing enough to qualify for any matching funds.

See Also: The 45 Cheapest Index Funds in the ETF Universe

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