Why You Should Be Wary Of Target-Date Funds

By Tim Parker | May 08, 2012 AAA

It's the "in thing" now; everybody's doing it, so why wouldn't you? Here's how the story repeatedly plays out, especially for those who recently opened a new 401(k) or 403(b) account. The benefits manager of your company sent you a big stack of documents and told you to complete the application. You thumbed through everything, skimming the microscopic print in these pamphlets called prospectuses, and found yourself completely overwhelmed.

Luckily, as you were completing the application, you noticed that you could either pick your own investment options or choose the ready-made option that placed all of your retirement funds into a target-date fund. You didn't know what it was, but you didn't know how to pick your investment options anyway, so into this target-date fund is where your money has gone.

SEE: Roth, 401(k), 403(b): Which Is Right For You?

What Is a Target-Date Fund?
The concept is very simple. A target-date fund adjusts the assets in the fund to line up with your retirement timeline. If you're planning to retire in 15 years, you might pick a target-date fund of 2025 or 2030. The fund manager will adjust the holdings and when you near retirement age, that fund will hold a lot of bonds, instead of the more risky stocks.

You don't have to worry about adjusting your investment portfolio because the fund does it for you. If you don't have the time or desire to learn how to manage your retirement portfolio, these target-date funds might be a great idea.

As your grandparents might have said, if it's too good to be true, it probably isn't and that might be the case with target-date funds.

The Whole You
First, you are more than a date. Knowing that you plan to retire in 2025 or 2030 isn't enough information to assemble your retirement portfolio; imagine a doctor asking nothing more than your age. Your investment portfolio should be crafted around your tolerance for risk, the other assets you own, your family situation, social security and more. A target-date fund doesn't take any of that into account, because it's designed for a large amount instead of you, personally.

They Might Cost a Lot
According to Consumer Reports, the median expense ratio of target-date funds is 0.68%, compared to 0.71% for stock funds. That isn't bad if your plan offers a target-date fund around the median, but the median expense ratio of index funds, a fund that tracks the performance of a certain investment index, is only 0.5% and you can find index funds for as low as 0.1%.

In general, actively managed funds, funds that have a team of people picking stocks and bonds in an attempt to beat the overall market, will cost more, but over the long term they don't perform any better than an index fund that is cheaper.

They're Hard to Understand
Target-date funds are like a brand new car. They look good on the outside but they're hard to figure out when you open the hood. A recent SEC study found that many people believed that a target-date fund guarantees an income stream at retirement much like an annuity or a pension.

Others believed that once the fund reached the target-date, no more allocation changes in the fund were made. Both of these facts are untrue but this, along with the fact that a 2025 fund may vary greatly between companies, makes these funds dangerous for investors to take at face value.

The Bottom Line
Regardless of what you read today or in the future, there is no one investment product that will address all of your investing needs. A combination of products that may include a target-date fund is the best way to insure your retirement needs are met. Diversification will likely always be the best way to protect and grow your portfolio.

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