Target-date funds are a popular choice among investors for retirement savings, but like any investment they have pros and cons that need to be considered.
Target-Date Funds: An Overview
Target retirement funds are designed to be the only investment vehicle that an investor uses to save for retirement. Also referred to as life-cycle funds or age-based funds, the concept is simple: Pick a fund, put as much as you can into the fund, then forget about it until you reach retirement age.
Of course, nothing is ever as simple as it seems. While simplicity is one of the pros of these funds, investors still need to stay on top of fees, asset allocation, and the potential risks.
- Target-date funds provide a simple way to save for retirement.
- They offer exposure to a variety of markets, active and passive management, and a selection of asset allocation.
- Despite their simplicity, investors who use target-date funds need to stay on top of asset allocation, fees, and investment risk.
Advantages of Target-Date Funds
There are two types of target-date funds from which you can choose: target date and target risk.
Simplicity of Choice
A target-date fund operates under an asset allocation formula that assumes you will retire in a certain year and adjusts its asset allocation model as it gets closer to that year. The target year is identified in the name of the fund. So, for instance, if you plan to retire in or near 2045, you would pick a fund with 2045 in its name.
With target-risk funds, you generally have three groups from which to choose. Each group is based on your risk tolerance, whether you are a conservative, aggressive, or moderate risk-taker. If you decide later that your risk tolerance has or needs to change as you get closer to retirement, you have the option of switching to a different risk level.
Who Actually Benefits From Target-Date Funds?
Something for Everyone
Target retirement funds offer something for everyone. You can find funds that feature active management, passive management, exposure to a variety of markets, and a selection of asset allocation options are all available. Investors who are comfortable designating a percentage of their retirement, then forgetting about it for 30 years may be completely comfortable with target retirement funds. In addition, investors who do not mind doing a little research might find the exact fund they are looking for in the target fund lineup.
Just because the fund says 2045 on the label does not mean that a raging bull market will start and end just in time to keep the fund at the top of its game—nor does it mean that a severe bear market will not hit in 2044 and decimate the fund's holdings.
Disadvantages of Target-Date Funds
There are several disadvantages that investors need to consider, including:
Not All Funds Are Created Equal
The first challenge with target-date funds is that all funds are not created equal. A sample of approximate holdings (as of Aug. 31, 2020) with a target date of 2045 demonstrates this point.
|Fund||Equity Proportion||Fixed Income Proportion||Equity Allocation||Fixed Income Allocation|
|Fidelity Freedom® 2045||92.9%||7.1%||51.78% U.S. Equities||6.0% Bonds|
|41.16% International Equities||1.1% Short-Term Debt & Net Other Assets|
|T. Rowe Price Retirement 2045 Fund||93.1%||7.0%||62.9% US Equities||2.3% International & High Yield Bonds|
|30.2% International Equities||3.0% Investment Grade Bonds|
|Vanguard Target Retirement 2045||91%||9.0%||55.3% Total Stock Market Index||6.0% Total Bond Market II Index|
|35.7% Total International Stock Index||3.0% Total International Bond Index|
While each of these funds claims to be a good choice for investors seeking to retire in 2045, the contents of the funds are different. Keep in mind that this proportion may vary even more over time. That variance can be of particular concern to retirees. One retiree may have enough money on hand to invest strictly in bonds and other fixed-income securities. Another, requiring both growth and income, may need an equity component to keep the portfolio on track. A fund that meets the needs of one of these investors is unlikely to meet the needs of the other.
Beyond holdings, the funds also differ in terms of investment style. For instance, depending on what you are looking for, you can find a fund that is is made up entirely of index funds. Based on algorithms, such a fund is likely to have lower fees (see below). But investors who prefer active management, with actual human beings tracking market trends and making choices would need to shop elsewhere. Finding a fund with the right date is just the beginning of the decision process.
Expenses Can Add Up
Funds also differ in terms of expenses. Since each is a fund of funds, the portfolio you buy into consists of multiple underlying mutual funds, each of which has an expense ratio. Depending on how the fund family calculates fees, those expenses can add up quickly. For instance, one fund company may charge 0.21% of assets under management while another may charge twice or even three times that amount. As such, expenses must be a point of consideration when choosing these funds.
Underlying Funds Offered By Same Company
Beyond expenses, another consideration is that each of the underlying funds in a target portfolio is offered by the same fund company. Every target fund in Vanguard's lineup has nothing but other Vanguard funds inside the portfolio. The same goes for the Fidelity and T. Rowe funds. In an era with more than a few corporate scandals on record, you are trusting all of your assets to a single fund family.
Choosing a fund is one thing, but correctly implementing your retirement savings strategy is another thing altogether.
Effect of Other Investments
Investors who have their assets in a target retirement fund need to be aware of how other retirement investments could skew their asset allocation. For example, if a target fund has an 80% stock and a 20% bond asset allocation, but the investor purchases a certificate of deposit with 10% of their retirement assets, this effectively decreases the stock allocation of the investor's overall portfolio and increases the bond allocation.
Pre-Retirement Asset Allocation
Even investors who use the funds as their sole retirement investment vehicle need to pay attention to the overall asset allocation because this allocation changes as the target date nears. Generally, funds are designed to move to a more conservative funding position to preserve assets as the investor gets closer to the target date. If retirement is fast approaching but the balance in the investor's account isn't enough to meet their retirement needs, this allocation change will leave the investor with a fund that may have no hope of providing the type of returns required to keep those retirement plans on track.
Similar concerns emerge once retirement age is reached. While many investors view these funds as being designed to provide for retirement on or around a certain date, assets can be left in the fund after retirement. Here again, the size of the nest egg may indicate that a conservative strategy is not enough to keep the bills paid and the lights on.
Last but not least, reaching retirement by the chosen date is not just a function of choosing a fund and putting all of your money into that fund, it is also about putting the right amount of money into that fund. Regardless of the chosen date, an under-funded nest egg will simply not support a financially secure retirement.