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Every fund has to pay its managers and cover normal operating expenses. That's where the annual management fee comes in. Whatever the rate of return generated by the fund, it will be reduced by the amount of the annual fee.
According to the pros, allocating your assets skillfully among the various classes of investments is more important than your selection of individual stocks or mutual funds.
However, for many busy professionals and business owners, the challenge of asset allocation is either too complicated or too time-consuming to bother with. If you feel that way, the so-called "lifecycle" or "target retirement" mutual funds are made to order for you.
When it comes to managing your money, nothing could be simpler than target retirement funds.
They're well-diversified and investors who include them in their 401(k)s earn higher returns than those who don't, according to studies by consultants Hewitt Associates. More than half of the larger 401(k)s now offer these funds, and by the end of 2006, Hewitt expects to see them in as many as two-thirds of 401(k) retirement plans. Considering that lifecycle and target retirement funds have been around for only ten years, that's quite a testament to their public acceptance.
Each target retirement fund has a target year as part of its name, such as 2020, 2025 or 2030. The idea is that you pick a fund with a target year that is closest to the year that you will turn 65. For example, if you're age 50 now, you'd choose a fund with a target year of 2020.
At first, your fund will be made up largely of investments in domestic and international stock funds with the remaining balance in bond funds. As you near retirement age, the fund managers will gradually change its asset allocation to a more conservative mix by moving some of your money out of stocks and into bonds. The rebalancing of assets will continue even after you retire. By the time you reach 80, your investments will be almost entirely in bonds. In other words, money management professionals will do the onerous job of examining your asset allocation and rebalancing your investments as you age.
What could be simpler? You buy an age-designated fund and forget about the ups and downs of the market, not to mention the worrisome job of shifting your assets around as you age.
Most of the big fund families now offer these funds. My personal favorite is the Vanguard Group. In keeping with their reputation for low management fees, Vanguard charges about 0.2 percent a year for their target retirement funds. Among other low-cost providers are Fidelity's Freedom Funds ranging from 0.56 percent to 0.79 percent and T. Rowe Price's retirement funds at 0.57 percent to 0.81 percent.
There are many others; however, you should stick with those that charge less than 1.0 percent per year. There is no reason for you to pay more.
Aggressive or conservative?
Of course, there is much more to a fund than its management fees.
The investing philosophies of individual managers will determine how much the funds allocate to stocks at various ages. When you reach age 65, one fund may have you invested at 55 percent or more in stocks while a more conservative fund may hold 45 percent or less in stock at the same age. A more aggressive allocation may earn you higher returns, while the more conservative funds will expose you less to the worrisome vacillations of the stock market.
Many of the fund families seem to be adjusting their thinking with regard to allocation of stocks at retirement age. Some of the funds that aimed for 45 percent in stocks at age 65 are raising that target to 50 percent to enhance long-term growth potential.