Mutual funds are one option investors may consider when building a retirement portfolio. A mutual fund represents a pooled investment that can hold a variety of different securities, including stocks and bonds. There are different types of mutual funds investors may choose from, including index funds, target date funds and exchange-traded funds (ETFs).
But how do mutual funds work? Are mutual funds good for retirement or are there drawbacks to investing in them? What should be considered when choosing mutual funds for retirement planning?
Those are all important questions to ask when determining the best ways to build wealth for the long term.
Understanding Mutual Funds
A mutual fund pools money from multiple investors, then uses those funds to invest in a bunch of various securities. Mutual funds can hold stocks, bonds, short-term debt, and other types of securities.
How a mutual fund is classified or categorized can depend largely on what the fund invests in and what type of investment strategy it follows. For example, index funds follow a passive investment strategy, as these funds attempt to mimic the performance of a stock market benchmark. So a fund that tracks the S&P 500 index would attempt to replicate the returns of the companies included in that index.
Target-date funds, on the other hand, utilize a different strategy. These funds automatically adjust their asset allocation based on a target retirement date. So a 2050 target-date fund, for example, may shift more of its asset allocation toward bonds or fixed-income and away from stocks as the year 2050 approaches.
Exchange-traded funds or ETFs, meanwhile, trade on an exchange just like stocks. This is a departure from the way mutual funds are typically traded, with the price being set at the end of the trading day.
How Mutual Funds Work
Mutual funds work by allowing investors to purchase shares in the fund. Purchasing shares makes them part-owner of the fund and its underlying assets. As such, investors have the right to share in the profits of the fund. So if a mutual fund owns dividend-paying stocks, for example, any dividends received would be passed along to the fund’s investors. Likewise, bond fund investors could reap the benefits of interest payments.
Depending on how the fund is structured or what the brokerage selling the fund offers, investors may be able to receive any dividends or interest as cash payments or they may be able to reinvest them. With a dividend reinvestment plan or DRIP, investors can use dividends to purchase additional shares of stock, often bypassing brokerage commission fees in the process.
Investors pay an expense ratio to invest in mutual funds. This reflects the annual cost of owning the fund, expressed as a percentage. Passively managed mutual funds, including index funds and target date funds, tend to have lower expense ratios. Actively managed funds, on the other hand, tend to be more expensive but the idea is that higher fees may seem justified if the fund produces above-average returns.
Investors can learn more about how a particular mutual fund works, what it invests in, and the fees involved by reading the fund’s prospectus.
Mutual Funds for Retirement Planning
Mutual funds are arguably one of the most popular investment options for retirement planning. According to the Investment Company Institute , 46% of U.S. households totaling approximately 102.5 million individual investors owned mutual funds in 2020. Ninety-four percent use them to invest as part of their overall retirement plan.
So are mutual funds good for retirement? Here are some of the pros and cons to consider.
Pros of Using Mutual Funds for Retirement
Investing in mutual funds for retirement planning could be attractive for investors who want:
• Simplified diversification
• Professional management
• Reinvestment of dividends
Investing in a mutual fund can offer exposure to a wide range of securities, which can help with diversifying a portfolio. And it may be easier and less costly to purchase a single fund that holds 10 or 20 stocks than to purchase individual shares of each of those companies. For example, say you have $3,500 to invest. You could use that money to buy a single share of Amazon (AMZN) or invest in a mutual fund that owns Amazon and several other tech stocks.
Mutual funds are professionally managed, so investors can rely on the fund manager’s expertise and knowledge. You don’t need to be as hands-on as you would need to be if you were day trading individual stocks. And if the fund includes dividend reinvestment, you can increase your holdings automatically which can make it easier to grow wealth.
Cons of Using Mutual Funds for Retirement
While there are some advantages to using mutual funds for retirement planning, there are also some potential disadvantages, including:
• Potential for high fees
• Overweighting risk
• Tax inefficiency
As mentioned, mutual funds and ETFs carry expense ratios. While some index funds may charge as little as 0.15% in fees, there are some actively managed funds with expense ratios well above 1%. If those higher fees are not being offset by higher than expected returns (which is never a guarantee), the fund may not be worth it. Likewise, buying and selling mutual fund shares could get expensive if your brokerage charges steep trading fees.
While mutual funds make it easier to diversify, there’s the risk of overweighting one’s portfolio — owning the same holdings across different funds. For example, if you’re invested in five mutual funds that hold the same stock and that stock tanks, that could drag down your portfolio.
Something else to keep in mind is that a mutual fund is typically only as good as the fund manager behind it. Even the best fund managers don’t always get it right. So it’s possible that a fund’s returns may not live up to your expectations.
On the other hand, you may also have to contend with unexpected tax liability at the end of the year if the fund sells securities at a gain. Just like other investments, mutual funds and ETFs are subject to capital gains tax. Whether you pay short- or long-term capital gains tax rates depends on how long you held a fund before selling it.
• Mutual funds offer convenience for investors
• It may be easier and more cost-effective to diversify using mutual funds vs. individual securities
• Investors benefit from the fund manager’s experience and knowledge
• Dividend reinvestment can make it easier to grow wealth
• Some mutual funds may carry higher expense ratios than others
• Overweighting can occur if investors own multiple funds with the same underlying assets
• Fund performance may not always live up to the investor or fund manager’s expectations
• Income distributions can result in unexpected tax liability for investors
Investing in Mutual Funds for Retirement Planning
The steps to invest in mutual funds for retirement are simple and straightforward.
1. Start with an online brokerage account, individual retirement account (IRA) or 401(k). You can also buy a mutual fund directly from the company that created it but a brokerage account or retirement account is usually the easier way to go.
2. Set your budget. Decide how much money you can afford to invest in mutual funds. Keep in mind that the minimum investment for a particular fund can vary. One fund may allow you to invest with as little as $100 while another might require $1,000 to $3,000 to get started.
3. Choose funds. If you already have a brokerage account, this may simply mean logging in, navigating to the section designated for buying funds, selecting the fund or funds and entering in the amount you want to invest.
4. Submit your order. You may be asked to consent to electronic delivery of the fund’s prospectus when you place your order. If your brokerage charges a fee to purchase mutual funds, that amount will likely be added to the order total. Once you submit your order to purchase mutual funds, it can take a few business days to process.
Determining If Mutual Funds Are Right for You
Whether it makes sense to invest in mutual funds for retirement can depend on your time horizon, risk tolerance, and overall investment goals. If you’re leaning toward mutual funds for retirement planning, here are a few things to consider.
When comparing mutual funds, it’s important to understand the overall strategy the fund follows. Whether a fund is actively or passively managed may influence the level of returns generated. The fund’s investment strategy may also determine what level of risk investors are exposed to.
For example, index funds are designed to meet the market. Growth funds, on the other hand, typically have a goal of beating the market. Between the two, growth funds may produce higher returns — but they may also entail more risk for the investor and carry higher expense ratios.
Choosing funds that align with your preferred strategy, risk tolerance, and goals matters. Otherwise, you may be disappointed by your returns or be exposed to more risk than you’re comfortable with.
Cost is an important consideration when choosing mutual funds for one reason: Higher expense ratios can drain away more of your returns.
When comparing mutual fund expense ratios, it’s important to look at the amount you’ll pay to own the fund each year. But it’s also important to consider what kind of returns the fund has produced historically. A low-fee fund may look like a bargain but if it generates low returns then the cost savings may not be worth much.
It’s possible, however, to find plenty of low-cost index funds that produce solid returns year over year. Likewise, you shouldn’t assume that a fund with a higher expense ratio is guaranteed to outperform a less expensive one.
It’s important to look under the hood, so to speak, to understand what a particular mutual fund owns and how often those assets turn over. This can help you to avoid overweighting your portfolio toward any one stock or sector.
Reading through the prospectus or looking up a stock’s profile online can help you to understand:
• What individual securities a mutual fund owns
• Asset allocation for each security in the fund
• How often securities are bought and sold
If you’re interested in tech stocks, for example, you may want to avoid buying two funds that each have 10% of assets tied up in the same company. Or you may want to choose a fund that has a lower turnover rate to minimize your capital gains tax liability for the year.
Other Types of Funds for Retirement
Mutual funds, and target date funds in particular, are one way to save for retirement. But there are other options you might consider. Here’s a brief rundown of other types of funds that can be used for retirement planning.
Real Estate Investment Trusts (REITs)
A real estate investment trust isn’t a mutual fund, per se. But it is a pooled investment that allows multiple investors to own a share in real estate. REITs pay out 90% of their income to investors as dividends. You may consider a REIT if you’d like to reap the benefits of real estate investing (i.e. diversification, inflationary hedge, etc.) without actually owning property.
Exchange-Traded Funds (ETFs)
Exchange-traded funds have already been mentioned but they’re worth discussing again as a retirement savings option. Investing in ETFs can offer more flexibility compared to mutual funds. They may carry lower expense ratios than traditional funds and be more tax-efficient if they follow a passive investment strategy.
Recommended: Benefits of ETFs
An income fund is a specific type of mutual fund that focuses on generating income for investors. This income can take the form of interest or dividend payments. Income funds can be an attractive option for retirement planning if you’re interested in creating multiple income streams or reinvesting dividends until you’re ready to retire.
Bond funds focus exclusively on bond holdings. The type of bonds the fund holds can depend on its objective or strategy. For example, you may find bond funds or bond ETFs that only hold corporate bonds or municipal bonds while others offer a mix of different bond types. Bond funds are generally considered on the safe side and they may help round out the fixed-income portion of your retirement portfolio.
An initial public offering or IPO represents the first time a company makes its shares available for trade on a public exchange. You could invest in individual IPOs or you could invest in multiple IPOs through an ETF. IPO ETFs invest in companies that have recently gone public so they offer an opportunity to get in on the ground floor.
Mutual funds can be part of a diversified retirement planning strategy. Regardless of whether you choose to invest in mutual funds, ETFs or something else, the key is getting started sooner rather than later. Time — and the power of compounding interest — can be one of your most valuable resources when investing for retirement.
Looking to get a jump on a retirement savings account? SoFi Invest® offers a variety of investment products to suit different risk tolerance, personal goals, and time horizons.
Photo credit: iStock/kali9
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.