A Look at Target-Date Funds
Are these low-maintenance investments vital to retirement planning, or overrated?
Do target-date funds represent smart choices, or just convenient ones?
These funds have become ubiquitous in employer-sponsored retirement plans and their popularity has soared in the past decade. According to Morningstar, net inflows into target-date funds tripled during 2007-13. Asset management analysts Cerulli Associates project that 63% of all 401(k) contributions will be directed into Target-Date Funds by 2018.
Fans of target-date funds praise how they have simplified investing for retirement. Still, they have a central problem: their leading attribute may also be their biggest drawback.
How do Target-Date Funds work?
The idea behind a target-date fund is to make investing and saving for retirement as low-maintenance as possible. Target-Date Funds feature gradual, automatic adjustment of asset allocations in light of an expected retirement date, along with diversification across a wide range of asset classes. An investor can simply “set it and forget it” and make ongoing contributions to the fund with the confidence that its balance of equity and fixed-income investments will become more risk-averse as retirement nears.
In a sense, a Target-Date Fund starts out as one style of fund for an investor and mutates into another. When he or she is young, it is an aggressive growth fund, with as much as 90% of the inflows assigned to equities. By the time the envisioned retirement date rolls around, the allocation to equities and fixed-income investments may be split closer to 50/50.
With such long time horizons, Target-Date Funds are truly buy-and-hold investments. That has definite appeal for people who lack the time or inclination to take a hands-on approach to retirement planning. Target-Date Funds also usually have low turnover, with some distributions taxed as long-term capital gains.
Are pre-retirees relying too heavily on Target-Date Funds? Putting retirement investing on “autopilot” can have a downside – and that may be worth an alarm or two, given Vanguard’s forecast that 58% of its retirement plan participants (and 80% of its new plan participants) will have all of their retirement plan assets in Target-Date Funds by 2018. So in noting the merits of Target-Date Funds, we must also look at their demerits.
The asset allocation of a target-date fund is not exactly dynamic. As it is geared to a time horizon rather than current market conditions, Target-Date Fund investors may wince when a severe bear market arrives – it could be a case of “set it & regret it.” They will need the patience to ride such downturns out. If they sell, they defeat the purpose of owning their Target-Date Funds in the first place.
Additionally, some investors are conservative well before they reach retirement age. A fortysomething risk-averse investor might not like having a clear majority of his or her Target-Date Funds assets held in equities.
An investor will not be able to perform any tax loss harvesting with assets invested in a Target-Date Fund (that is, selling “losers” in a portfolio to offset gains made by “winners”) and if all of his or her retirement savings happen to be in the Target-Date Fund, you have to pull money out of the Target-Date Fund to put it in other types of investments that might generate tax savings.
Fees can be high, because most Target-Date Funds are funds of funds – that is, multiple mutual funds brought together into one giant one. So this may mean two layers of fees.
The glide path is very important. All Target-Date Funds have a glide path, the glide path being the rate or pace at which the asset allocation changes from aggressive toward conservative. With some Target-Date Funds, the glide path ends at retirement and the asset allocation approaches 100% cash. With others, the fund keeps gliding past a retirement date with the result that the retiree maintains a foot in the equities market – potentially very useful in the face of longevity risk, or as it is popularly known, the risk of outliving your money. The glide path of the Target-Date Fund should be agreeable to the investor. The problem is that an investor may agree with it more at age 40 than at age 60.
A new feature may make Target-Date Funds even more appealing. In October 2014, the IRS and the Treasury Department permitted Target-Date Funds held in 401(k) plans to add a lifetime income option. That would let a TDF investor receive a pension-like income beginning at the fund’s target date. Companies sponsoring 401(k)s can even elect to make such Target-Date Funds the default plan investment; that is, employees who wanted to direct their money into other investment vehicles would have to inform their employers that they were opting out.
Younger retirement savers may want to take a look at Target-Date Funds. If you are not enrolled in one already, you may want to weigh their pros and cons. While not exactly “the cure” for America’s retirement savings problem, they are definitely popular.
Jay’s Take: I am more of a fan of buying individual stocks and ETFs to save on fees and have greater control of your money. Our VIP Program provides asset allocation models, ETF and stock recommendations, and a better way to help you manage your retirement assets. If you have a current 401k plan at work you should look into whether it allows in-service withdrawals or a brokerage-link option so you can have more options and choices for your retirement dollars. For a 401k at a previous job, I would consider rolling that over to an IRA.
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