Zeroing in on Target-Date Funds

Are target-date funds the right choice to meet your retirement investing goals? According to a recent target-date retirement fund study, 77% percent of retirement plan participants are hoping so. What’s the attraction? Target-date funds offer investors the ability to create a risk-appropriate asset allocation across multiple asset classes that automatically rebalances over time – all by purchasing a single fund.

The investment strategy is based on limited criteria: The funds either allow you to select the year you will retire, or they select it automatically based on age. As retirement gets closer, the allocation becomes more conservative.

Target-Date Retirement Funds: A Snapshot

At the end of 2020, total assets in target-date strategies were approximately $2.8 trillion, according to a target-date fund report.1 That’s a huge increase over 2008 when the industry held just $158 billion in assets.2 Part of the reason for the growth is that target-date funds (TDFs) are often the default option on many 401(k) plans. Employees are automatically enrolled in an age-appropriate TDF when they sign up, and then many never bother to revisit their investment choices until they get serious about retirement.

Target-date funds are essentially a wrapper in which mutual funds of a variety of asset classes are combined in different weightings. A younger investor would be primarily invested in equity funds, and as the time to retirement decreased, the fund would increase the weighting to bond funds. This gradual process is referred to as a “glide path” because it traces a long, slow movement from as much as 90% equities for a younger investor to about 60% equities by the time the investor gets closer to retirement. TDFs can be an effective asset allocation vehicle, as they may combine different styles and geographies of equities, and different durations and types of bond funds.

The convenience of the built-in asset allocation and automatic rebalancing comes at a price. Target date funds may have higher expense ratios than other investment products. For example, they may have a higher expense ratio than a fixed allocation balanced fund would, due to the active rebalancing feature.

Is an Asset Allocation Based on Retirement Date Comprehensive Enough?

Target date funds were originally conceived to be the only investment in an investor portfolio. For a younger investor without a lot saved, or for a plan lacking many other options, this works well. And because they are “hands-off,” they may prevent emotional investment decisions driven by changing market conditions, which can often have a negative impact on performance.

The difficulty comes as careers progress and retirement assets begin to grow. A target-date fund offered in one plan can be vastly different from a TDF from another plan, even if they both have the same retirement date. The risk profiles may be different, and the underlying investments will be different. Since many investors may have several jobs – and therefore several retirement plans with different investments over the course of a career – getting a clear picture of what the total investing landscape is can be a challenge.

For an investor with a sizeable balance who can put a good amount to work across a broad asset allocation, adding other strategies to a target-date fund may provide an opportunity to create a more customized plan. Also, if an investor decided they wanted to retire earlier or work longer than originally planned, the target-date fund may not be able to accommodate changing time horizons.

What Happens as Retirement Gets Closer? Or Begins?

An important thing to keep in mind when investing solely in TDFs: With target-date funds, the shift towards conservative investments as the target date approaches may not provide sufficient income for all of retirement. This is exacerbated if the investor had a few years of lower contributions, or if there were several years of poor market returns, resulting in a lower-than-expected balance.

While an investor can of course remain invested in TDFs, or even extend the date beyond the beginning of retirement to attempt to create more growth potential, taking the initiative to create an asset allocation that allows for a bucketed strategy may be a better approach to retirement planning. This can ensure that current income needs are met and allow for some growth potential.

Another consideration is that once distributions begin, they’ll be considered taxable income. Setting up a plan in retirement that provides enough income is only half the story. Managing the tax bite so that you keep the income you’ve generated is a big part of a successful retirement plan. For this reason, many investors may choose to roll over a 401(k) into a standard IRA or a Roth IRA that can provide broader investment options, including tax efficiency.

The Bottom Line

While target-date funds do have some unique attributes that can make investing for retirement on your own a little bit easier, limiting yourself to this type of investment may impact the amount of control you have in the long run. Talking with an advisor can help determine if target-date funds make sense for your situation and can also provide alternative solutions that may better align your investment portfolio with your goals and financial plan.

1. Sullivan, James. Target-Date Fund Assets Up, Flows Down. 401(k) Specialist. March 22, 2021.

2. Cross, Daniel. History of Target-Date Funds. Mutualfunds.com. May 29, 2018.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or personalized financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.