Target-date funds are often a popular choice for investors who want to build their retirement portfolio with minimal fuss. Through September 2016, target-date funds accounted for 18.4% of the $3.28 trillion in total defined contribution plan assets among the 1,000 largest retirement plans.
While target-date funds take some of the guesswork out of planning your investment strategy for retirement, there’s one very important question you must consider: Where does a target-date fit into your investment plans once you actually retire? The good news is, you have several options to choose from. (See: An Introduction to Target-Date Funds.)
Target-Date Funds: Pluses and Minuses
Target-date funds are attractive for investors on two different levels. First, they eliminate some of the stress of choosing investments. Instead of trying to pick individual stocks, bonds or mutual funds, a target-date fund comes with a predetermined asset allocation, based on your timeline until retirement.
Second, target-date funds tend to offer consistent performance. Research from Morningstar indicates that target-date fund investors generally experience results that are 74 basis points better than other types of fund investments. With some investments, such as taxable bonds and international equity funds, the return gap is negative.
There are, however, some downsides. Once you enter retirement and begin making withdrawals from your investments, for example, certain assets may offer more flexibility than others. When you own stocks and bonds outside of a fund, you can sell them individually as needed, but with a target-date fund you’re selling shares of the fund itself so there’s no ability to pick and choose which investments you liquidate. (See: The Pros and Cons of Target-Date Funds.)
Managing These Funds in Retirement
Deciding what to do with target-date funds you hold in an employer-sponsored plan once you reach your target-date years is important if you’re concerned about maintaining a similar level of performance without overcomplicating your investment choices. Ultimately, there are three primary options to consider.
1. Leave target-date fund assets in your former employer’s 401(k).
If your 401(k) plan has a balance of $5,000 or more, your employer can’t make any distributions from the plan without your consent. That means you can leave your target-date funds or any other funds you’ve invested in the plan right where they are once you retire. While you can’t make any new contributions to the plan, your investments can continue to grow on a tax-deferred basis until you begin making withdrawals. At age 70½, you’re required to begin taking minimum distributions from the plan. 401(k): Pressure's on to Leave It at Your Old Job explains more of the details.
2. Roll over the target-date fund into an IRA.
The second option is to roll your target-date fund assets from your employer’s plan into an individual retirement account (IRA). The advantage of doing so is that it allows you the freedom to invest in something other than target-date funds if you wish. Target-date funds are by nature designed to become more conservative as time progresses, so if you’re comfortable taking on more risk, a rollover would give you more freedom in your investment choices.
Just remember that if you’re initiating a transfer of funds from your plan’s trustee to yourself, 20% of the assets being transferred will be withheld automatically for taxes. If you don’t roll the money into your new plan within 60 days, the funds will be treated as a taxable distribution.
3. Cash out your target-date fund assets.
The final choice is to simply cash out your employer’s plan and reinvest the money elsewhere. This option offers the most flexibility, since you could invest in more than just stocks, bonds or funds. You could use some of the money to invest in real estate through crowdfunding, for example, or purchase a rental property. The catch, however, is that you’ll owe ordinary income tax on the amount you withdraw from the plan. (See: How to Minimize Taxes on 401(k) Withdrawals.)
Beware of Fees
One thing to keep in mind if you decide to maintain target-date funds in your retirement portfolio is the cost. Between 2009 and 2015, the average expense ratio for target-date funds declined from 1.03% to 0.73%, according to Morningstar. Across all funds, however, the average expense ratio was 0.64% in 2015, making target-date funds more expensive by comparison.
In some instances, target-date funds may double up on the fees. With “funds of funds,” for example, you may pay an expense ratio for the fund itself, along with management fees for the underlying investments. If your target-date fund moves towards a more conservative bent once you’ve retired, excessive fees could significantly shrink your returns.
The Bottom Line
Target-date funds may be better suited to certain types of investors than others. Although these funds allow for a relatively hands-off approach, you should be prepared to take action once your investments reach their target year. Weighing the benefits and drawbacks of leaving target-date funds in your 401(k), rolling them over to an IRA or cashing out your plan altogether can help you decide which strategy fits best with your retirement plans.