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Target-Date Funds: Pros & Cons

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Key Points

  • Target-date funds tend to be the default employer-provided retirement account investment, but other options are usually available.

  • Target-date funds can be good for beginning investors or for those who might resort to frequent trading during market ups and downs.

  • Because they don’t adjust to financial and life circumstances, target-date funds increase your risk of inefficient outcomes.

If you’ve enrolled in your employer-provided 401(k) plan, you’ve likely seen funds with the name “target date” or “target retirement” followed by a future year (e.g., 2040). Known as a lifecycle or age-based fund construction approach, assets are managed upon the assumption you’ll retire in or near that given year. Given the dramatic rise in usage of target-date funds, let’s explore what you’re really getting when investing in these funds.

What Is a Target-Date Fund?

Although first designed in the 1990s, target-date funds didn’t gain traction until the passing of the Pension Protection Act in 2006. The legislation allowed target-date funds to be a participant’s default investment election. Unless you choose otherwise, this is the investment in your retirement account. As a result, there is around $2.5 trillion dollars invested in target-date funds within the United States, making these funds a major player in the retirement investment industry.

When looking at their investment construction and management, you’ll see 2 key characteristics of target-date funds. The first is a “fund of funds” approach. When a target-date fund manager picks its holdings, rather than buying individual stocks, bonds, etc, they buy stock funds, bond funds, etc, which contain the individual assets. The underlying holdings are funds across multiple asset classes, typically all from the same company. It also means you’re likely to pay a bit more in fund management fees on top of the cost of the underlying funds.

The second, and most important feature, is the fund’s asset allocation glide path. A glide path, such as the example below, is a process of set asset allocation changes across time as determined by the fund’s manager(s).

A target-date fund glide path gradually reduces the fund’s risk as it approaches its target retirement date. When the target date is reached, the mix between equity and fixed income typically stays fairly steady, though some funds might make minor adjustments even after the target date occurs.

The variables that distinguish one target-date fund’s glide path from another are: 

  1. The magnitude of change in asset allocation

  2. The amount of time between changes

  3. Whether the final asset allocation change occurs at the target date year or some period afterwards.

Reasons to Consider Using Target-date funds

Having a single investment holding where the participant can sit back and enjoy a hands-off approach, letting the fund manager make all the asset allocation decisions, can be appealing to someone who doesn’t have the time or interest in actively reviewing their investments periodically.

Target-date funds can also be a good fit at smaller account balance levels. If you’re just getting started saving for retirement, you may understandably not feel comfortable in choosing multiple investment options and deciding the allocation percentages to each.

Similarly, these funds can be good if you’re nervous about the market and might otherwise be tempted to frequently trade investments in the account. Such trading could lead to inefficient asset allocations or trigger fees and lock out periods for funds.

Occasionally, a participant might have an employer-provided plan where most or all other investment choices have higher investment fees, or the plan is missing access to key asset classes. You may find that the target-date fund is the most reasonable option.

In many cases however, target-date funds can fall short compared to an approach that researches, selects, and allocates between a few specific funds from a plan lineup and is followed up with periodic monitoring.

When a Specific Fund Allocation Approach Is Better

The major concern with target-date funds comes down to 3 words: lack of control.

As a target-fund investor, by design, you have no control over asset allocation. Target-date funds are designed to a “one size fits all approach.” There is no ability to tailor the account to a participant’s unique circumstances, a fact that’s likely to lead to inefficient outcomes the longer the account is left on autopilot. Target-date funds cannot factor in the value and asset allocation of other financial assets a participant has available to them. They can’t react to sudden life changes such as a loss of job or medical disability. In the same vein, target-date funds are unable to adjust for changes such as risk tolerance, changes in planned or actual retirement age, and life expectancy.

In addition to target-date funds, many employer-provided retirement plans likely include excellent index-based investment options for specific asset classes for the same or lower cost. This enables individual investors or their financial advisors to recommend an investment plan more tailored for your situation.

As assets within target-date funds have become substantively material in recent history, it’s critical to understand the pros and cons of these funds. While target-date funds provide some level of course adjustment via the asset allocation glide path over the years, the one-size-fits-all approach has serious constraints.

If you’re willing to do a little research and periodic planning — or hire a financial advisor to do it —a better investment plan can be found in most employer-provided retirement plans at an equivalent or lower cost level. At Capstone, we enjoy reviewing plan investment options and providing customized investment plans for our clients.

 

Disclosures:

This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.