Target-date funds are one of the most popular investment vehicles found in the portfolios of 401(k) holders. But is that a good thing? Here’s a look at whether your investment portfolio should have this type of fund – or if you can put that money to work in better ways.
What Is a Target-Date Fund?
It is possible that you have one of these funds – basically, a type of mutual fund – but know nothing about them. That's probably because target-date funds were created to be one-stop shopping for your retirement money: You decide on the year you plan to retire, then pick a target-date fund that is closest to that year. If you aim to retire in 2035, for example, you might pick the American Funds 2035 Target Date Retirement Fund. The fund automatically allocates your assets to a mixture of stocks and bonds that fit what the managers believe should match your risk tolerance. As you get closer to that 2035 target date, the fund rebalances your asset allocation, moving it more heavily toward bonds and other safer investments.
It’s an easy way to invest, especially if you know very little about stocks and bonds. That’s why, at the end of 2013, 41% of employee 401(k)s had a target-date fund among its assets. That’s also why brokerages will automatically enroll employees who don’t specify their investment options into target-date funds. By 2019, analysts expect that $2 trillion of assets will be in these funds, representing 88% of all 401(k) money.
No one can argue the convenience of these funds. They take all of the work out of investing for someone who knows little to nothing about how to make his or her money grow. Your retirement money is arguably the most important asset you have. You want professionals managing its growth for you. target-date funds are professionally managed, and for most, it’s the type of investment they feel OK forgetting about. If you’re not in the financial services field, you may not have time to learn how to invest properly. Your time may be better spent growing your career and leaving your money management to the pros.
Data also show that target-date fund investors are outperforming people in regular mutual funds. If you’re currently in a target-date fund, you’re seeing,on average, 1.1% better performance than the fund itself. In contrast, people in other mutual funds under-perform the fund by around 1% See Who Actually Benefits From Target-Date funds? and When to Use Target-Date Funds for more.
No investment vehicle is perfect. As an investor, you have to choose the least imperfect option. But there are some important issues to consider with target-date funds.
Risk Tolerance – Every good financial adviser will ask you about your risk tolerance because age isn’t the only factor. Two 40-year-olds could have wildly different risk tolerances because of their personality types and experiences. target-date funds aren’t designed to take into account the risk tolerances of a varying investor base. However, different funds targeted to the same year may have different philosophies (see next section), so be sure the one you choose matches your comfort level. Read more in An Introduction to Target-Date Funds.
Asset Allocation – There’s no standard asset allocation based on age. Each fund invests a bit differently depending on the beliefs of the management team. Two funds with a target date of the same year could have very different proportions of stocks versus bonds. Some might be more invested in overseas investments than others, or one may consider tax efficiency more than another. There are variables affecting performance that the average employee may know little about.
Fees and Expenses – Unlike pure stocks and bonds, funds have fees attached to them. Managers don’t work for free and the fund itself incurs expenses that are subtracted from its returns. Like any business, those fees vary depending on numerous factors. The Vanguard Target Retirement 2035 fund has an annual expense ratio of 0.18%, while the T. Rowe Price Retirement 2035 Fund has an expense ratio of 0.74%. The higher the number, the more of your returns go to expenses, not to your account. That’s money out of your pocket.
People Don’t Know How to Use Them – If you invest in a target-date fund, the general rule is not to have any other assets. If you add other funds into your mix, it throws off the weighting of the fund. Instead of having an 80% allocation of stocks as you head toward your 2035 retirement date, for example, you might have 90% if you’re holding another stock fund. That’s probably too high.
The Bottom Line
Should you ditch your target-date fund? Keep in mind that the goal of investing is to get the best return with appropriate risk while paying the lowest fees. Target-date funds are simple to understand on the surface, but because a 401(k) isn’t likely to offer many choices for these funds other than date, a regular index fund might be a better choice depending on its fees, expenses and return. (See Index Investing and Target-Date vs. Index Funds: Is One Better?)
Compare your options to decide. If you know very little about investing, get advice from a trusted financial advisor, who doesn’t earn commissions based on the advice he or she gives you.