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If you have a 401(k) plan, and about 60 million Americans do, you’re likely investing in a target-date fund. In fact, they are the default option for many plans and help explain why they account for nearly a quarter of 401(k) plan assets, according to the Plan Sponsor Council of America.
Of course, target-date funds are not limited to retirement plans. Financial advisors use these, and so do many DIY investors.
Without a doubt, such funds can be a useful tool to facilitate retirement planning. However, these are not a panacea for everyone, and some investors may want more.
Here’s what you need to know:
Target-date funds tend to have maturities in five-year intervals, such as 2040, 2045, or 2050. The end date roughly coincides with when investors plan to retire. By rebalancing holdings over time, managers can help ensure each fund has an age-appropriate mix of stocks and bonds, taking the guesswork out of planning for retirement. can.
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In addition to simplicity, another potential benefit is the pricing structure. Passively managed target date funds have expense ratios as low as 0.08%. Granted, this is more expensive than many exchange-traded funds or mutual funds that track indexes, but it’s cheaper than actively managed options within the same fund family.
At their best, target date funds are like a good meal kit service. Many people don’t know how to cook, don’t want to cook, or don’t have time to cook. That’s why they rely on companies that send them all the pre-portioned ingredients and instructions they need to make delicious meals.
Similarly, savers often have simple needs but don’t have the time or know-how to build an investment portfolio that will continue to fit their risk profile into adulthood. For them, target date funds can be a good option.
However, there are some important caveats.
First, target-date holdings may be too conservative for many young investors. Consider that Vanguard and Fidelity’s 2060 target-date fund versions, currently aimed at investors in their 20s, have relatively high fixed income ratios: 9.7% and 13.32%, respectively.
When you’re that young, the diversification benefits of bonds – lower volatility and more stable reinvestment rates – are mostly theoretical. In reality, bonds may just limit your potential gains.
Second, the management approach may be too formulaic for many investors. First, the composition of target-date funds and the reallocations that occur over time suggest that the only factor determining an investor’s risk profile is the investor’s age. This involves many other factors, such as assets and liabilities.
Another issue here is diversification. Vanguard’s 2060, 2050 and 2040 target-date funds have at least 30% of their assets invested overseas, a market sector that has underperformed U.S. stocks for about 15 years. Diversification is a good thing, but simply diversifying can affect your business performance.
Finally, passively managed target-date funds are usually reasonably priced, while actively managed funds can be expensive. For example, the Fidelity Freedom 2060 Fund has an expense ratio of 0.75%, but most plan-based financial advisors are willing to invest in that by using mutual funds or ETFs that may perform better at a lower cost. You can almost reproduce the approach.
As it turns out, there are a variety of target date funds. For people with somewhat simple needs, who perhaps don’t have a large amount of investable assets and are not inclined to work full-time with a financial advisor, these can be an economical way to invest and build wealth. I get it.
At the same time, target-date funds have several drawbacks, many of which highlight the value of financial advisors, but also the ability of asset managers to take the guesswork out of retirement planning with target-date funds. Which is ironic considering what they’re advertising.
In reality, no financial advisor can perfectly time the market and lock in big profits every year, but the formulaic, flexible margins that many target-date fund managers tend to employ You can go beyond a fleeting or bland approach.
— Andrew Graham, Founder and Managing Partner of Jackson Square Capital
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