Target Date Funds: Pros and Cons
Despite their enormous popularity, Target Date Funds (TDFs) have shortcomings that are not likely to go away. They also have several benefits that have propelled their usage in retirement planning. 401(k) plans had no TDF assets in 2006 to almost $2 trillion at the end of 2018. Some experts believe the asset amount will approach $7 trillion by the end of 2025.
Following are some of the pros and cons of TDFs that every investor should be aware of.
Target Date Fund: Pros
They are very popular as default investments in 401(k) plans when people are not comfortable selecting individual investments such as individual mutual funds.
Selecting investments means investors should research the fund alternatives (track records, investments, expense ratios) before they invest in them and they have to manage their own asset allocations – how much goes in Fund A, Fund B, Fund C, and so on.
Millions of Americans are intimidated by the process or are too apathetic to commit the time to manage their own assets. It is much easier to pick a TDF based on future retirement date and let the mutual fund family do the work.
People refer to TDFs as a “one decision investment process” that does not require research, rebalancing, or reallocations. People can pick a retirement year and forget it.
TDFs are Easy to Use and Understand
TDFs do all the heavy lifting for investors who want diversified portfolios and reduced risk as they approach their retirement dates. Plan trustees also want these characteristics for participants who simply cannot make investment decisions.
It is pretty simple to decide to work to age 65, determine the year, and select a fund.
TDFs Can Produce More Prudent Results
Many plan participants will not diversify their investments if they are left on their own. Very often they take excessive risk to earn higher returns, even when it is clearly more prudent not to. This can lead to excess risk-taking during their working years.
TDFs are highly diversified to reduce the risk of large losses. This diversification benefits people during down years.
Plan Trustees Like TDF Glide Paths
TDFs use glide paths that cause funds to become more risk averse over time. Declining risk tolerance is part of the aging process when people have less and less time to recover from bad markets.
Glide paths start when we are young and terminate the year we retire. Younger investors have higher exposures to more volatile asset classes (stocks) and glide paths cause this exposure to decline as they age. This is the classic trade-off between risk and reward. People can take more risk when they are younger to earn higher rewards. This ability to take risk declines with age.
Target Date Fund: Cons
Because TDFs are mutual funds all investors are treated the same in particular funds. On the other hand, there can be numerous differences between investors that can impact how they accumulate assets for retirement.
For example, there can be substantial differences between two 50-year-old investors. One is very dependent on the assets in a 401k and the other is not. One is in relatively good health (longevity) and the other is not. One is financially secure and the other is not.
Excessive Risk at the Target Date
Based on surveys, the typical TDF is invested 55% in stock market at the target date. This mix produced a negative 30% return in 2008 and TDFs have become riskier since then. This makes TDFs a ticking time bomb that will do the most damage to those near retirement because their account balances are their peak and they have no time to recover. Their alternatives are to defer retirement dates, reduce standards of living, or take part-time jobs.
Retirees Are Not Best Served
TDFs average about 45% in equities throughout retirement years. Research shows that this is too risky for early retirees. Optimal glide paths in retirement start at less than 20% in equities and increase over the next 30 years to about 45% in equities.
Personalized target date portfolios address these problems
Individual investors can do much better than investors in 401(k) plans who are limited to the TDF provider that is chosen by their employer. Namely, individuals can construct portfolios that are designed to achieve their unique objectives, and that follow a personal glide path versus a universal glide path.
About the Author: Ron Surz is CEO and CIO of GlidePath Wealth Management an innovative money management firm that uses a patented investment process to invest retirement assets that are held outside qualified retirement plans. GlidePath manages Target Date, Invest-for-100, Special Situations and Recession Protection Portfolios.