Are target-date funds the right choice to meet your investing goals?
Like anything, it depends.
Many Millennials and Gen Xers hold target-date funds in their investment accounts. And target-date funds provide investors a convenient way to save into a fund that offers multiple asset classes that automatically rebalance over time.
However, the fund determines the asset allocation on narrow criteria. The fund typically determines the asset allocation (the mix between different stocks and bonds) using the year you will likely retire or your age. With these funds, the allocation becomes more conservative as you get older and retirement gets closer. Target-date funds operate under a one-size-fits-all assumption. That unisex t-shirt may look great on your sibling, but not on you. The same applies to target-date funds. Which means it may or may not work best for your situation.
Understanding Target-Date Funds
Target-date funds (TDFs) are often the default option for many 401(k) or 403(b) plans. When employees sign up, their retirement plan can automatically enroll them in an age-appropriate TDF, and many never bother to revisit the investment. But that is not going to be you!
TDFs are a collection of various asset classes combined with different weightings. The primary asset classes are equities (stocks) and bonds (fixed-income). The fund primarily invests in equity funds for young participants, and as the time to retirement decreases (the target date), the fund increases the weighting to bond funds. Equities are typically riskier, meaning we expect a higher return as investors (it doesn't mean you get it, tho). And bonds are more conservative because they tend to be less volatile. However, with less risk, there should be less return expected.
A glide path is this gradual process of moving from more equities to more bonds over time. Glide paths trace a slow transition from as much as 90% equities for a younger investor to about 60% equities (or less) by the time the investor retires. Each fund family has its own glide path, and the fund's management determines the glide path. Below is a sample graph illustrating a hypothetical glide path.
TDFs can be a convenient asset allocation vehicle, as they may combine different styles and geographies of equities. Furthermore, the fund may have different durations and types of bonds.
The Pros and Cons of Target-Date Funds
Portfolio managers who manage target-date funds assume the fund you hold is the only asset in your portfolio. With this assumption comes pros and cons. Here is a summary of the pros and cons of target-date funds.
Pros
Straightforward to implement with typically low minimums.
The fund manages asset allocation, meaning less work for you.
Professionally managed.
Cons
Potentially higher expense ratios.
The asset allocation may be too conservative or too aggressive for your goals.
The fund's asset allocation may not fit within your broader portfolio's needed allocation and diversification.
The Pros
TDFs offer investors convenience. TDFs can work well for a younger investor just starting without a lot saved. They are easy to implement and can be a good alternative if your retirement plan lacks other reasonable investment options. And because they are "hands-off," they may prevent emotional investment decisions driven by changing market conditions. Emotionally charged investment decisions can impact performance. Owning a professionally managed fund removes you from the decision process of how to allocate your savings. The convenience of TDFs is immense.
The Cons
The convenience of the built-in asset allocation and automatic rebalancing can come at a price. Target-date funds may have higher expense ratios than other investment products. And the asset allocation may leave one wishing for more diversification. Again, these are one-size-fits-all tools.
The difficulty comes as your career progresses and your income grows. With more income, typically, there are more savings. Thus, a single retirement plan may not be your only asset. You may have a taxable account, an IRA, or real estate investment assets.
Furthermore, as you move through your career, you will likely have multiple retirement plans from past employers. A target-date fund offered in one plan can be vastly different from a TDF from another, even if they both have the same retirement date. The risk profiles may be different, and the underlying investments can be different. So, getting a clear picture of your total investment portfolio becomes more difficult. When this happens, it may make sense to consider consolidating retirement accounts.
With target-date funds, the shift towards conservative investments as the target date approaches may not provide sufficient income for all of retirement. In other words, transitioning from riskier to less risky assets may result in a lower than required expected return to reach your retirement goals. This problem is exacerbated if you had a few years of lower contributions or if there were several years of poor market returns, resulting in a lower-than-expected balance.
Also, if an investor decides they want to retire earlier or work longer than initially planned, the target-date fund may be unable to accommodate changing goals.
Another consideration is that withdrawals may be taxable income once distributions begin. Setting up a plan for retirement that provides enough income is only half the story. Managing the tax bite so that you keep the income you've generated is a big part of a successful retirement plan. For this reason, savers should develop a plan that considers taxes.
Working With TDFs
An investor may choose to use a TDF because it is the best option they have among the choices provided by the retirement plan. When this happens, you should do some planning. If you need to take more risks to reach your goal, consider investigating a fund with a target date beyond the beginning of retirement to create more growth potential. Additionally, supplementing the target-date fund with other tactics may provide an opportunity to create a more customized plan. This can be done by supplementing your retirement plan savings with separate accounts such as IRAs or taxable accounts.
Are you trying to figure out where best to save your hard-earned money? Download our 18-point checklist, which outlines the accounts you should consider if you want to save more.
The Takeaway
While target-date funds have some unique attributes that can make investing for retirement on your own a little bit easier, limiting yourself to this type of investment may impact the amount of control you have in the long run. As with anything related to your financial plan, you should set it and monitor it (as opposed to forgetting it).
Talking with a planner can help determine if target-date funds make sense for your situation and provide alternative solutions that may better align with your goals and financial plan. Working with a trusted financial planner can reduce your stress and help you map out the best course of action for your situation. At Pursuit Planning and Investments, LLC, I help you think through your options. I help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your goals and begin best optimizing your financial plan in that meeting.
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