Is a Target-Date Fund the Best Choice?

Target-date funds continue to be a popular choice among investors. However, will such a fund give you the retirement lifestyle you deserve? (For more, see An Introduction to Target Date Funds.)

The normal retirement playbook says that, as you get older, the ratio of stocks to bonds in your retirement portfolio should change. At the beginning of your career you can take more risk because you most likely won’t need the money  for decades. For that reason a higher percentage of higher-risk stocks makes sense. As you get closer to retirement you have to better protect your assets, so you should have a higher percentage of bonds. A target-date fund makes all those weighting adjustments for you. Think of it as an automatic financial planner.

Statistics show the popularity of these funds. In 2015 target-date funds represented 20% of assets among 401(k) savers, and 47% of twentysomethings held them in their retirement plans. By the end of 2015, 60% of newly hired employers held target-date funds representing at least 30% of their assets.

Part of the reason for the explosion is because the funds are often the default investment choice for 401(k)s. If you meet with your human resources person or maybe a plan advisor, they’re likely to steer you toward a target-date fund because it allows for a hands-off approach to retirement planning – a set-it-and-forget-it type of model.

Just because everybody is doing it doesn’t necessarily mean that it’s right for you. As financial advisors are quick to point out, financial situations differ by individual. Are you the right person to snub target-date funds and instead put together your own mix of stocks and bonds? If your retirement funds are inside a 401(k), you won’t have a lot of choices in most cases, so putting together an actual mix of stocks and bonds isn’t possible. However, you could pick other assets outside of target-date funds.

Target-date funds come at a price. You have to pay good money to have a fund that automatically adjusts on your behalf. The average fund has an expense ratio of 0.51%. That means that your $10,000 investment will cost you $51.00 per year just for the service the target-date fund offers. That might not seem like much, but the fees add up. One study found that over a 40-year career you could lose $590,000 of savings just in fees.     

In contrast, an index equity mutual fund, which simply tracks the performance of the market, could come in at less than 0.1% in fees or $10 per $10,000 invested. You could have a stock index fund and a bond index fund and make weighting adjustments on your own or with the help of a financial advisor. (For more, see 401(k)s: Index Funds vs. Target-Date Funds.)

Another problem with target-date funds is that they adjust the weightings based on your retirement year, when, in fact, your finish line is the day you die. Because of that the fund might end up too conservative, leaving you with a lot of money lost in fees and not enough gains to retire in the way you would like.

Let’s give target-date funds some credit. For people who aren’t going to follow investment markets, learn how to invest and take a hands-on approach to their retirement, target-date funds are a fine choice. They’re even a smart move for people who are inclined to frequently change their fund allocation inside their 401(k). Studies have found that target-date funds help to keep people disciplined in their investing choices, which increases returns.

Another positive is the trend toward lower fees. In 2010 the average expense ratio for target-date funds was 1.02%. In 2016 it was half of that. If fees continue to fall, the hands-off approach to investing will become even more attractive.

If you invest in target-date funds, that should be the only investment in your 401(k). Don’t make the mistake that so many 401(k) holders make and try to use them to complement other funds. They aren’t designed for that. If you’re going to do it, go all the way.

Target-date funds will likely be more expensive and provide lower returns than a self-created portfolio of passively managed index funds. But unless you have a fair amount of investing knowledge – or work with a financial advisor to help you allocate your investments properly, based on your unique financial situation – you may be better off choosing the target-date fund. If you do, many financial advisors recommend that you choose a target date that is much later than your projected retirement date. That way you continue to earn adequate income after you retire. (For more, see What to Do When Your Target-Date Fund Reaches the Target Year.)