Using Age-Based Funds in Your 401(k)

Many people are so busy they don't have time to follow their portfolios. Most haven't had the necessary training or education to understand the ins and outs of investing. The good news is that there are funds out there that take the guesswork out of where to put your money, based on your age and your tolerance for risk.

These funds go by several names, such as age-based allocation models, age-based funds, or target-date funds. They are designed to automatically adjust your portfolio over the years as you approach the age at which you hope to retire.

Age-Based Funds vs. Lifestyle Funds

Age-based funds are normally set up like mutual funds. Generally, the younger you are, the more risk your fund will take on since you have time to make up for any significant losses. As you age, the fund takes on less risk in preparation for your pending retirement and your dependence on the funds for income.

Target-risk funds, or lifestyle funds, also rate assets based on risk over time, but instead of being based on age, they are based on whether you consider yourself to be a conservative investor or a risk-taker.

Both lifestyle- and age-based funds invest your money in stocks, bonds, and cash. But lifestyle funds focus more on a person's risk tolerance, which could stay basically the same throughout a lifetime. Age-based funds automatically change as the person ages.

In a lifestyle fund, there are no changes unless the investor decides to move to a more or less aggressive fund. This requires action on the part of the investor. With an age-based fund, once the fund is chosen, no further action is necessary.

Traditionally, age-based funds have been thought of as retirement funds. At the same time, they are increasingly being used for 529 plans. A 529 plan is a mutual fund set up for college savings. The 529 fund changes its risk level as the beneficiary of the money gets closer to college age.

Misconceptions About Age-Based Models

There are misconceptions about age-based allocation models. For example, they may not be perfect for anticipating life expectancy past the time of retirement. Should someone retire early or live longer than average, the funds do not account for it.

These funds also offer no guarantees that your money will have maximized returns. They are not like a Social Security fund, from which one can expect a certain payout.

It is also important to remember that all target-date funds are not alike. They will vary significantly based on which fund family is chosen for the investment.

Finally, keep in mind that these are like mutual funds, in that they carry inherent risks. Just because something is risk-adjusted based on age, doesn't mean that there is no risk.

Their Allocation Mix

In a perfect world, we all would have the time to dive into the details of our retirement portfolios every year or so and rebalance them as appropriate. The nice thing about age-based funds is that, as we age, they are rebalanced for us.

This makes investing much simpler for those who don't have the time or market knowledge to make adjustments. Instead, the fund 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, moving securities around to bring the fund back into balance.

As with regular mutual funds, these funds have ratings, in order to give investors an idea of their safety and return. The fund's Morningstar Risk score assigns rating 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 it's a good idea to keep an eye on your fund to make sure its rating hasn't changed dramatically.

While evaluating funds, remember that because these funds are somewhat new, data on past performance may not be available as far back as for funds that have been on the market for many years.

There will still be expense ratios to consider, which will be listed in the fund's prospectus. Compare funds to see what fees they are charging.

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.

The Advantages of Investing in These Funds

These funds are also a great choice for the beginner investor. A young person just entering the working world may find that a fund like this is the ideal way to start investing. They can always go back later and move things around once they learn the investing ropes.

Age-based funds are also highly diversified. They can include stocks, bonds, cash, or other types of investments that many people may not fully understand. They may include international funds or specialized funds that few outside the financial world have ever heard of.

The Disadvantages of Age-Based Funds

If you need to have total 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.

Another possible disadvantage could be a 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.

The Bottom Line

Age-based funds offer some great advantages to those who prefer a hands-off approach. Still, these funds are not for everyone.

Even if you decide to invest in an age-based fund, it is wise to do as much research as possible and compare your available options. Compare the fee structures, and check out what they say on Morningstar or similar research sites about the funds suggested for you.