Retirement planning can be a complicated process—a process that helps you figure out how much income you'll need to live on when you retire, and how you'll achieve that goal. By doing so, you'll need to determine what sources of income you will need, what expenses you'll have, and how you'll be managing your resources.

One option to consider is a 401(k) plan. These are qualified employer-based programs that allow you tuck away contributions into a retirement fund from your salary on a pre- or post-tax basis. This is one of the most popular forms of employer-sponsored retirement plans in the country. But how do you start investing? A common question is whether or not to choose index funds or target-date funds from the investment options offered in your 401(k).

Key Takeaways

  • Index funds are passively-managed mutual funds that track a specific index.
  • Target-date funds are actively managed and are restructured at a future date to meet the needs of investors.
  • Index funds typically come with low costs, expenses, and long-term returns, and some risk.
  • Because they are actively managed, target-date funds are susceptible to more risk because they invest in high-performing assets.

Index Funds vs. Target-Date Funds: An Overview

Choosing between index funds and target-date funds in a 401(k) is a common dilemma. Index funds are generally a good, low-cost choice that is very investment-style specific. Target-date funds offer professional management. The choice should first be between either a target-date fund (or other managed account option) and the open funds on the menu, both active and index.

It is important for plan participants to understand the particulars of the target-date funds offered and most certainly that they don’t necessarily dampen investment risk, at least to the extent that some may think. Index funds can be a great choice but not all index funds are as low cost as others.

Index Funds

Index funds are a popular choice for both individual investors and financial professionals. These are mutual funds that are created to track a specific index like the S&P 500, the Russell 2000, the EAFE, and others. At best, these funds are style-specific. They also offer broad exposure to the market and have low operating expenses.

Index funds span the gamut of stock and bond investment styles both domestically and internationally. Others may track some obscure indexes that, in some cases, were created with back-tested data. These, however, rarely appear in 401(k) plans.

If a plan offers several low-cost index fund choices, perhaps an S&P 500 or total stock market index fund, an international stock index fund, and a bond index fund, there is enough variety to serve as the core of a diversified portfolio. Add index funds that cover small-cap stocks, mid-cap stocks, emerging market stocks and perhaps real estate investment trusts (REITs) and participants can easily build a well-diversified all-index fund portfolio.

These funds follow a passive management strategy. Fund managers choose securities that mirror the particular index the fund tracks, rather than active management, where fund managers buy and sell securities based on market timing. With index funds, the makeup of the portfolio changes when the benchmark index changes.

Index funds offer investors diversity, low costs, and long-term returns. But they are also susceptible to changes in the market and aren't very flexible.

Like any other investment, there is risk involved in index funds. Moreover, any risk that affects the benchmark will be seen in the index fund. If you're looking for flexibility, you won't find it with an index fund, especially when it comes to reacting to price drops in the index's securities. And because of the fees and expenses—as low as they may be—these funds may often underperform the index they track.

One thing to keep in mind, though. While most index funds are low cost, there are some that come with a high price. Case in point is the Rydex S&P 500 Index (RYSOX) with an expense ratio of 1.59%. This is astounding when you realize this is exactly the same product as the low-cost S&P 500 index funds mentioned above.

Target-Date Funds

Target-date funds are an alternative to consider if your company offers them. You can either invest all of a 401(k) account in the appropriate target-date fund or invest in a selection of the investments from the plan’s open lineup.

The reason why they're called target-date funds is that the assets are restructured at a future date in order to serve the needs of the investor. They are often named after the year in which they are meant to be used. Rather than having to choose a series of investments, an investor can choose one target-date fund to reach their retirement goals.

Generally, there will not be a choice in terms of the target-date fund family offered by a plan. Target-date funds can be found in many 401(k) plans. Most are funds of mutual funds, with the three largest providers being Fidelity Investments, T. Rowe Price Group, and The Vanguard Group. All three use their own funds as the underlying investments. Other firms may offer strategies, such as funds of exchange-traded funds (ETF), but using funds of mutual funds remains the most common structure.

Because they are actively managed, target-date funds tend to have higher expenses than passively-managed funds.

Target-date funds, like any investment, require thorough analysis to determine if they are the right choice. Retirement plan sponsors also need to perform their due diligence on target-date funds before offering them as an option in their company’s plan. There are wide variations in the equity percentages at the various target-dates and in the various glide path philosophies. The glide path is the reduction of equities into and during retirement until it flattens out at some age. This assumes you will hold the target-date fund virtually until death.

A common misconception is that target-date funds lower investing risk. This is not necessarily true. When they are launched, these funds invest heavily in high-performing assets and thus come with more risk. Assets are reallocated at regular intervals, and the risk is curbed as the fund gets closer to its target date.

Target-date funds did come under fire in 2008 when many shorter-dated funds suffered larger-than-expected losses. For example, the T. Rowe Price 2010 fund lost 26.71%, and the Fidelity Freedom 2010 fund lost 25.32%. These losses seem excessive for funds designed for investors within two years of retirement at that point in time. Don’t assume target-date funds provide an extra level of protection from downside risk than their asset allocation would imply.

Special Considerations

Actively managed mutual funds like target-date funds have gotten a bad rap, and in many cases, this is well deserved. However, not all actively managed funds are a bad investment choice. Many offer consistent returns, are well managed and have reasonable expenses. The choice isn’t index fund or target-date fund, rather its target-date fund (or other managed account option) or a menu of the other funds offered in the plan.

It is best to have an asset allocation in mind for those going this route. If the 401(k) plan is the only investment, then this account is the only one to worry about. For those that have other investment accounts such as an individual retirement account (IRA), a spouse’s workplace retirement plan, and taxable investments, a 401(k) plan allocation should be looked at as part of an overall portfolio.