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Fidelity's retirement funds, known as the Fidelity Freedom Fund, are designed to be the only investment that retirement savers need in their portfolio. These funds are known as target-date or lifecycle funds, and they come in two varieties -- index funds and actively managed mutual funds.
What is a target-date retirement fund?
A target-date retirement fund, also known as a "lifecycle" or simply a "target retirement" fund, is intended to be an all-in-one investment portfolio designed to help people save for retirement.
We have a thorough introduction to asset allocation here, but the basic idea is this. Stocks have the most potential for long-term growth but also tend to be rather volatile. So while the investors in these funds are still a long way from retirement, the vast majority of assets are invested in stock-based mutual funds.
On the other hand, bonds are much less volatile, but also tend to produce lower returns, making them more appropriate for older investors who have already grown their nest egg and are more focused on preserving their capital. Therefore, as investors approach retirement age, target-date funds gradually shift assets from stocks to bonds, and even to ultra-safe money market funds in some cases.
Index funds vs. actively managed funds
Fidelity's Freedom Funds come in two varieties -- with some portfolios made up of index funds and others made up of Fidelity's actively managed funds.
An index fund simply tracks a certain stock or bond index. For example, an S&P 500 index fund would invest proportionally in the 500 stocks that make up that index. A target-date retirement index fund would invest in a combination of index funds in order to achieve the desired allocation. Using a Fidelity fund as an example, the Fidelity Freedom Index 2040 Fund invests most of its assets in the Fidelity Total Market Index Fund (62%), the Fidelity Series Global ex U.S. Index Fund (27%), and the Fidelity U.S. Bond Index Fund (10%).
Because index funds don't require too much talent or effort to manage, they generally have significantly lower expense ratios than actively managed funds.
In a nutshell, an actively managed fund employs a fund manager (or managers) whose job it is to choose particular stocks or bonds to buy with the fund's assets. Because this requires more work and skill than managing an index fund, actively managed funds tend to have higher fees. In Fidelity's case, the 2040-targeted index fund I mentioned has a gross expense ratio of just 0.24% while the company's actively managed 2040 Freedom Fund has an expense ratio of 0.77%, more than three times that of the index fund.
However, if you're paying managers who are consistently beating the market, this could be money well-spent.
Fidelity's Freedom Funds
Fidelity's Freedom Funds come in five-year increments, currently ranging from 2005 for people who retired about a decade ago, all the way up to 2060 for savers just entering the workforce.
To give you an idea of how the gradually changing asset allocation works, here's the current makeup of some of Fidelity's Freedom index funds:
Data source: Fidelity. Investor shares were used for this example. Percentages may not total 100% because of rounding.
Keep in mind that the actively managed funds may have slightly different compositions, even for the same target date. After all, they are actively managed, which means that if the fund managers feel there is more opportunity in a certain asset class right now, they can use their discretion and change the allocation. However, they tend to have allocations that are within a few percentage points of the index funds -- but with assets invested in actively managed Fidelity funds.
Are the actively managed funds worth it?
I mentioned that, in theory, actively managed funds can be worth the higher fees if the performance justifies paying them. In Fidelity's case, the Freedom index funds haven't been around for too long, but here's a comparison of the past five years of performance for certain target dates. Note that these returns are expressed as annualized averages, and are inclusive of any fees.
Data source: Fidelity.
Now, five years of performance isn't really enough to draw a conclusion, but at first glance it appears that the actively managed funds have beaten the index funds across the board. And while these may seem like relatively small differences, you may be surprised at the difference a half-percent higher return each year can make over the long run.
The point is that while there's no guarantee that the actively managed Freedom Funds will continue to beat the indices, don't ignore them just because they seem more "expensive".
The bottom line
If you prefer a hands-off approach to retirement savings and don't want to worry about rebalancing your portfolio as you get older, a target-date retirement fund may be the way to go. Fidelity's Freedom Funds offer more variety than many other companies, and could fit nicely into your retirement planning strategy.
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Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.