In a previous life I worked as a financial education consultant, traveling the US and talking to my company’s retirement plan participants about their retirement plan. We focused on the basics. Why they should save in their 401(k). How the power of compounding interest can work for you. What is diversification? What is your risk tolerance? How do you use this information to choose how to invest your money?
I have long been a personal finance geek. But the reality is that the vast majority of people aren’t. And it can be downright overwhelming for the average 401(k) plan participant to figure out where to invest his or her money.
I was reminded of this fact recently. The company I work for does its match in company stock, and the stock has done so well over the long term that a lot of people are over-weighted in it (that’s a story for another day). A couple of months ago the stock hit a new 52-week high, and I decided it was a good time to move a little more of my match money out of company stock. I had a coworker who wanted to do the same, but she didn’t know WHERE to put the money once she sold the stock. The paralysis of having to make that decision almost kept her from taking any action at all.
Barry Schwartz outlined this phenomenon in his book, The Paradox of Choice. I may get overwhelmed by the wall of 50 different types of laundry detergent at Target, but many other people are paralyzed when their retirement plan offers too many options.
So what’s the average Joe to do? I couldn’t give advice to plan participants in my financial consultant role; I could only educate. But at the time I was in this job, target date funds were starting to become popular additions to retirement plan investment lineups. When our plans offered them, we would explain how they worked and how a participant could determine if it was the right choice.
So what is a target date fund? This link to Vanguard (one of my favorite investment companies and a FIRE community favorite) gives some of the highlights.
- You invest in one fund that does the diversification for you. In Vanguard’s case, the target date fund is a blend of their other underlying index funds. It is diversified to include a mix of US and international stocks and bonds.
- The asset allocation is based on the target retirement date. If you are far from retirement, it is more heavily weighted in stocks and as you move closer to retirement, the mix of investments gradually becomes more conservative.
- You don’t have to rebalance your investments – the fund company automatically does it for you.
Of course there are caveats to every recommendation, and every fund company that offers target date funds has it’s own style and approach (Vanguard’s 2040 fund will not be the same as Fidelity’s or T. Rowe Price’s). But don’t let the perfect be the enemy of the good – it’s better to have a solution that is 80% effective than to have no solution at all. I told my coworker that in her upcoming meeting with a financial advisor that she could get advice on where to invest for the long term, but in the meantime I gently steered her towards one of the target date funds offered by our 401(k).