How to Find the Best Mutual Funds for Retirement

Learn how to pick mutual funds for retirement like a pro

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With over 10,000 mutual funds on the market, it can be difficult to figure out which ones are the best to use in retirement. These strategies can help you pinpoint mutual funds that deliver on your vision for your retirement.

Choose Retirement Funds That Meet Your Goals

The best investments are designed to deliver on a specific retirement objective. Is your priority to achieve long-term capital appreciation—growth in the value of your investment over time—or to secure current income? Your preference will dictate which of the two main categories of mutual funds you select for your retirement portfolio: growth or income funds.

As the name implies, growth funds aim to substantially grow your principal, which is the original amount you invested in the fund. They do so by investing in the stock of companies that tend to yield above-average gains. These funds are ideal for investors who seek long-term capital appreciation.

Income funds, in contrast, invest in dividend-paying stocks and bonds in order to provide investors with income. These funds are appropriate for individuals who desire monthly income in retirement.

But when it comes to establishing retirement investment goals, growth or income is not an either-or. You can add both growth and income mutual funds to your retirement portfolio to achieve a balance between capital appreciation and income. In fact, a portfolio that features both growth-oriented funds invested in stock and income-oriented funds invested in dividend-producing stocks and bonds is more diversified because it contains multiple investment classes with varying levels of risk.

Factor Risk Tolerance Into Mutual Fund Selection

Your comfort level with potential ups and downs in returns on your investment is referred to as your risk tolerance. Are you willing to tolerate a higher level of risk to maximize the returns of your retirement mutual fund? Or, are you willing to sacrifice growth for a lower level of risk? Consider your risk tolerance when selecting mutual funds for your retirement portfolio.

In general, growth funds are subject to more fluctuations because they carry the potential for higher returns. They can soar in value in a rising market, but can drop just as significantly in a falling market. This makes them the best mutual fund option for retirement investors with a higher risk tolerance. That said, growth funds come with varying levels of risk. For example, aggressive growth funds that invest in riskier securities require a higher risk tolerance than conservative growth funds that invest in low-risk securities.

In contrast, income funds are less risky because they offer lower returns in exchange for income. They won't increase as sharply as a growth fund in a rising market, but they may not fall as substantially during a down market. For this reason, investors with a lower risk tolerance should consider income retirement mutual funds. As with growth funds, income funds come in various risk levels from conservative (low-risk) income funds that focus solely on producing income to aggressive (high-risk) income funds that offer income and capital appreciation.

Select Mutual Funds for the Right Time Horizon

Your time horizon is the number of years you have left until you retire, which will influence your investment goal, your risk tolerance, and, ultimately, your selection of mutual funds.

If you have a long time horizon—years or even decades until retirement, for example—your goal is more likely to be long-term capital appreciation. As such, your risk tolerance may also be higher. Despite the potential for a sharp decline in your funds during a downturn, the funds can bounce back by the time you start to withdraw from your retirement portfolio. A growth fund can support these objectives.

But if you have a shorter time horizon—a few years until retirement, for example—your goal is more likely to be to start withdrawals soon and to secure income. Your risk tolerance will also be lower, as a significant decline in your portfolio now could prevent you from retiring or limit your income in retirement. An income fund, which can help soften losses during a downturn, can deliver on these objectives and keep your mind at ease.

Many of the large mutual fund companies have put together a series of mutual funds designed just for retirement portfolios. These include target-date retirement funds, which contain a mix of stocks and bonds in a pre-set asset allocation (80% stock/20% bonds, for example). The allocation starts out more aggressive to promote growth and automatically becomes more conservative (invests in less stock and more bonds) as you get closer to retirement. Target-date funds present an alternative to hand-picking an array of different mutual funds.

Look for Retirement Funds With Low Fees

One thing that investors frequently overlook is the cost of holding a mutual fund, which is called an expense ratio. The company offering the fund imposes this fee on an annual basis as a percentage of your investment to help cover its operational expenses. The best retirement funds have lower expense ratios. They allow you to keep more of the returns on your investment, which results in a higher portfolio value at the time of retirement. In contrast, the higher fees of expensive funds can eat into your returns over time, resulting in a smaller nest egg.

For example, let's say that you're considering investing $100,000 in a mutual fund that has an expense ratio of 1% a year versus one that only charges 0.50% per year. The second fund saves you $500 a year in fees—money that can continue to grow in your retirement portfolio. The longer your time horizon until retirement, the more that extra $500 a year adds up.

A fee study by Morningstar put the average expense ratio for mutual funds and exchange-traded funds at 0.48%, but ratios can vary depending on the level of management required for the fund. Actively-managed funds have an average expense ratio of 0.67%, while passively managed funds that track major indexes cost only 0.15% per year.

Afraid a retirement mutual fund with lower expenses won’t perform as well? Think again. Lower-expense funds often outperform their peers with higher fees. For example, index funds are known to deliver solid performance with low fees. You can build a solid, low-cost retirement portfolio using funds index funds. Or, look at a pre-packaged solution using a retirement income fund, such as a target-date retirement fund.

Pre-packaged retirement funds often come with higher expense ratios than the individual funds they contain. If you're comfortable with a more hands-on investing approach, look at the mix of funds inside a packaged fund and then build your own portfolio containing the same funds to benefit from a lower expense ratio.

Don't Focus on Retirement Funds Alone

The best mutual funds for your retirement portfolio complement your investment goals, risk tolerance, and time horizon. To maximize your returns, choose funds with low expense ratios.

But remember: Selecting mutual funds for retirement is only one aspect of retirement planning. Many upcoming retirees spend too much time searching for the best mutual funds for their retirement portfolio, and too little time on other planning decisions. These include when to start withdrawals, how to plan for associated taxes, and when to take Social Security or pension distributions.

When these decisions are made appropriately, they can deliver more value than smart mutual fund selection alone. So do your retirement planning first; the last piece of the planning process should be choosing retirement investments. An experienced retirement planner can help you evaluate different plans and arrive at an effective overall retirement strategy.