4 August 2020

Target-Date Funds

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Nearly every retirement plan offers target-date funds as investment options. But are target-date funds a good choice? The age-based method of setting your asset allocation makes sense in some cases, but investors can also stay in a target-date fund too long. Put another way, if your financial situation has evolved over time, shouldn’t your investment strategy? Here’s how to decide if target-date funds are a good choice for your retirement account.  

What is a target-date fund?

A target-date fund is a diversified investment mix based on your age and the year you expect to retire. When you’re younger, the exposure to equity will be much higher, perhaps 90%. As you get closer to the target retirement date, the fund automatically gets more conservative, shifting away from stocks and more heavily into bonds.

Target-date funds are usually a fund of funds. As a type of wrapper, a target-date fund will typically hold different weightings of various other funds managed by the same company.

The popularity—and cost—of convenience

According to a recent Vanguard study, 77% of retirement plan participants were using at least one target-date fund. Age-based options are popular for several reasons. First, it’s a turnkey solution for investors who aren’t comfortable creating their own asset allocation. The fund manages all the rebalancing, so the investor can be hands-off.

Another reason for the rise in target-date funds isn’t about choice at all. Age-based funds are commonly the default investment option in 401(k) plans. Many busy executives never get around to considering a change.

Convenience doesn’t come without a cost, however. Morningstar reports that although costs have been declining, the average expense ratio for a target-date mutual fund is .62%. The expense ratio on an investment is essentially the price you pay the fund company to invest in that particular product. These costs eat into your return, so it’s an important factor when picking investments.

When to consider choosing a target-date fund

New accounts with smaller balances

Since target-date funds can offer a lot of diversification own their own, it can be a good option for employees starting a new job. Even if you’re maxing out your 401(k), if you have a handful of funds, the amount allocated to each might be quite small.

Depending on how much you contribute and if your employer matches, it could make sense to stay in a target-date fund for a few years while you build assets.

The other investment options in the plan are limited

There are situations where the underlying investments in the target-date fund (recall that it’s a fund of funds) are the only other funds in the 401(k) lineup. So you can either pick a target-date fund or make your own asset allocation using the exact same funds, only in weightings you choose. Depending on your needs and how the age-based options are structured, it may be easiest and/or more cost-effective to go with the turnkey option.

Or perhaps the non-target-date funds offered in the retirement plan are suboptimal. A lot goes into fund selection (or avoidance): perhaps the expenses are too high, the funds are poorly rated, or don’t have a long track record.

At the end of the day, if the target-date fund is your best investment option after weighing the alternatives, you should choose it.

Here’s when a target-date fund may not be a good choice

The Vanguard study also found that 52% of retirement plan participants were fully invested in one target-date fund. Over half! While the age-based option might still be the best choice for some of those investors, it’s unlikely the case for all of them.

Here are some of the situations where it may not make sense to pick a target-date fund. Like most financial decisions, this isn’t one you’ll want to make in a vacuum. Accordingly, many of the considerations listed throughout this article are interrelated.

If you have a sizable 401(k)

If you’ve been saving for 10 years or more and now have a significant amount of money in your 401(k), it might be time to consider upgrading your asset allocation to something more custom. Perhaps you want deeper diversification into other asset classes and sectors, such as real estate, global bonds, or small-cap equity.

Instead of investing a couple hundred dollars in each fund, as you would with a smaller account, now you may have tens or even hundreds of thousands of dollars to put towards each investment option. For busy executives, it can be easier to justify the time to properly manage a 401(k) once it’s reached scale.

Age isn’t an asset allocation

Again, the target-date investment options have their place, but investors should be aware that age alone can’t get you to the right asset allocation. It’s a helpful starting point, but there are other factors you’ll want to consider as well. In addition to your own personal risk tolerance, below are some situations where age-based allocations could miss the mark.

Investing in a vacuum

If you have other investment accounts, like a brokerage account or an IRA, it often makes sense to develop an asset allocation for all of your accounts as one portfolio. Then you can look at each account to fulfill different components. This is often a big advantage of having a fiduciary financial advisor manage the investments in your 401(k) plan, too.

In a simplistic example, assume a retirement plan has good choices for large-cap U.S. equity and corporate bonds, but there isn’t a real estate (REIT) option and the international equity fund has a high expense ratio. It may make sense to select only the two best options in the 401(k) and backfill the ‘missing’ asset classes in IRAs.

Do you have a pension or other income?

Target-date funds aren’t intended to account for your entire financial picture. If you have a sizable pension or other sources of income in retirement, consider factoring that in. In some situations, it may make sense to consider a pension as part of your fixed income allocation. Otherwise, you might be invested more conservatively than you’d like.

Your early retirement may not be accounted for

Target-date funds assume investors will retire around 65. So the asset allocation grows more conservative with the assumption that the money needs to last for 20-30 years. But what if you want to retire at 50 or 55? Now your savings will need to last a lot longer. Without enough equity exposure, the odds of running out of money in retirement increases.

If the plan gives you better, cheaper options

If you can create your own investment mix and get closer to the allocation you prefer, consider it. Especially if it reduces your investment costs. Risk and return go hand-in-hand, so weigh the pros and cons on a risk-adjusted basis, net of expenses.

Some 401(k) plans also offer brokerage windows, which permit plan participants to access investments outside of their retirement plan, almost as though it’s a rollover IRA.

Are target-date funds a good choice?

Target-date retirement funds definitely have their place in the investment universe. Independent of the options in the plan, depending on your comfort level, managing the account yourself may not be realistic. Age-based funds provide guardrails, and there is nothing wrong with that.

But don’t automatically assume it’s the best choice for your retirement savings without further scrutiny. Considering your entire financial situation and the alternatives in your 401(k) plan can help ensure you are making the best choices for your retirement investments.

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