Target-date funds continue to be a popular choice among investors. However, will a target-date fund give you the retirement lifestyle you deserve? We look at some of the pros and cons of putting your investments in a target-date fund.
- Target-date funds help to create a passively-indexed portfolio that automatically rebalances based on your time until retirement.
- However, target-date funds may not be suitable for all investors since they can limit your investment choices and decisions.
- It's important to note that target-date funds may be more expensive than other index funds and are usually a one-size-fits-all strategy.
What’s a Target-Date Fund?
The normal retirement playbook says that, as you get older, the ratio of stocks to bonds in your retirement portfolio should change. At the beginning of your career, you can take more risk because you most likely won’t need the money for decades. For that reason, a higher percentage of higher-risk stocks makes sense.
As you get closer to retirement, wealth preservation becomes more important. As a result, investors should typically reallocate their investment holdings so they have a higher percentage of fixed-rate investments such as bonds, which are debt securities issued by governments and corporations. The fixed interest payments from bonds help to create a steady stream of income and reduce the volatility or price fluctuations in the portfolio.
A target-date fund makes all of those weighting adjustments for you. Think of it as an automatic portfolio manager. So, if you expect to retire in the year 2040, you could simply purchase a 2040-target date fund—set it and forget it.
The Statistics Are Clear
Statistics show the popularity of these funds. As of 2020, more than 50% of 401(k) investors have all of their 401(k) assets in target-date funds. More than 75% of investors have a portion of their money (retirement or non-retirement) in at least one target-date fund, according to a study from Vanguard, which is a leading index-fund provider.
Part of the reason for the explosion is because the funds are often the default investment choice for 401(k)s. If you meet with your human resources representative or maybe a plan advisor, they’re likely to steer you toward a target-date fund because it allows for a hands-off approach to retirement planning.
Who Actually Benefits From Target-Date Funds?
Should You Follow the Herd?
Just because everybody is doing it doesn’t necessarily mean it’s right for you. As financial advisors are quick to point out, financial situations differ by individual. Are you the right person to snub target-date funds and instead put together your own mix of stocks and bonds?
If your retirement funds are inside a 401(k), you won’t have a lot of choices in most cases, so putting together your own actual mix of stocks and bonds might not be possible. However, you could pick other assets outside of target-date funds.
They Can Be Expensive
Target-date funds, however, often come at a higher cost than other passively-managed funds. You have to pay a fee to have a fund that automatically adjusts on your behalf. The average fund has an expense ratio of 0.51%. That means your $10,000 investment will cost you $51.00 per year just for the service the target-date fund offers. That might not seem like much, but the fees add up over time. A portfolio with $10,000 invested over 20 years with a 0.50% expense ratio will lose $6,000 to fees over the period.
Investors who have a few hundred thousand dollars in the market over 20-to-40 years can expect to pay well over $100,000 in fees by retirement. It's important for investors to pay attention to a fund's expense ratio since they can eat into your returns and retirement savings.
In contrast, an index equity fund, which simply tracks the performance of the market, could come in at less than 0.05% in fees or $10 per $10,000 invested. Index funds are not actively managed, meaning securities are not bought and sold by a portfolio manager as in the case of actively managed mutual funds. You could have a stock index fund and a bond index fund and make weighting adjustments on your own or with the help of a financial advisor.
Where’s the Finish Line?
Another problem with target-date funds is that they adjust the weightings based on your retirement year, when, in fact, your finish line is the day you die. Because of that, the fund might end up too conservative, leaving you with a lot of money lost in fees and not enough gains to retire in the way you would like.
Should You Do It Yourself?
Let’s give target-date funds some credit. For people who aren’t going to follow investment markets, learn how to invest, and take a hands-on approach to their retirement, target-date funds are helpful. They’re even a smart move for people who are inclined to frequently change their fund allocation inside their 401(k). Studies have found that target-date funds help to keep people disciplined in their investment choices, which increases returns.
Another positive is the trend toward lower fees. The expense ratio on many target-date funds has fallen dramatically over the past decade as they have shifted to holding mainly low-cost index funds. If fees continue to fall, the hands-off approach to investing will become even more attractive.
A Word of Caution
If you invest in target-date funds, that should be the only investment in your 401(k). Don’t make the mistake that so many 401(k) holders make and try to use them to complement other funds. They aren’t designed for that. If you’re going to do it, go all the way. Another mistake people make is to spread out their investments between a few target-date funds—this is also a misstep. Pick one target-date fund that matures when you expect to retire and then go in 100%—otherwise, you are defeating the purpose.
The Bottom Line
Target-date funds will likely be more expensive and provide lower returns than a self-created portfolio of passively managed index funds. But unless you have a fair amount of investing knowledge or work with a financial advisor to help you allocate your investments properly, based on your unique financial situation—you may be better off choosing the target-date fund. If you do, many financial advisors recommend that you choose a target date that is much later than your projected retirement date. That way, you continue to earn adequate income after you retire.