Are Target Date Funds Good Or Bad?
If you have a 401(k), chances are you’ve been advised by a fund manager or your company’s plan representative to invest in target date funds–also referred to as retirement date funds and lifestyle funds.
Or, perhaps when you signed up for your plan, you were automatically enrolled into a target date fund (such as 2030, 2040, or 2050 funds).
More and more Americans are being told the set-it-and-forget-it strategy is their best option for growing their retirement savings.
The rationale is that it’s easier and simpler for the average investor because investment strategies are combined into one mutual fund that’s structured to automatically adjust account allocations as the investor moves through different life stages. As you age toward your target retirement date, the funds shift toward more conservative investments to reduce risk.
Target date funds might make investing for retirement easier for the average person, but are they effective in helping people maximize their savings?
More and more experts claim target date funds don’t perform as well as average investors are led to believe.
Citing studies by institutional advisory firm Research Affiliates, Barron’s associate editor Randall W. Forsyth wrote in a February 2019 article, “They [the studies] show that the standard ‘glide path’ of target-date funds, which start heavily weighted in stocks and reallocate to bonds in later years, doesn’t produce the desired results.”¹
According to Rob Arnott, chairman of the board of Research Affiliates…
In response to Arnott’s statement, MarketWatch wrote in February 2019, “A trillion dollars is an understatement. In the U.S. alone, target-date funds held $1.11 trillion in assets at the end of 2017 and were growing about 7% a year.”³
Despite these warnings, target date funds continue to rise in popularity. According to the “How America Saves 2018” report, 51% of 401(k) investors in the study were solely invested in a single target date fund.⁴
And The Vanguard Group predicts more than three-quarters of its 401(k) investors will be solely invested in an automatic investment program by 2022.⁵
So, here’s the million-dollar question…
If target date funds may not perform better, why are so many companies automatically enrolling employees in them?
Let’s break it down.
Why Are Target Date Funds So Popular?
Simplifying the Investment Process
Target date funds will rebalance asset allocations as we age over time.
Once you pick your target date fund, or if your company automatically puts you in one, the fund manager offers risk management and ongoing diversification. While this does not eliminate risk, it automatically provides you, the investor, access to different asset classes.
Rather than having to select funds and balance stocks and bonds, or spending time and energy researching and learning how to manage your assets, target date funds simplify the investment process.
This appeals to average investors because they can set up their 401(k), regularly contribute, and let it do its thing and grow until retirement.
Target date funds make investing easy if you don’t have the time or knowledge to hand-select investments.
In addition, fees for target date funds continue to decrease, and, according to Morningstar, they are on a “Multiyear downward trend hitting a weighted expense ratio of 0.66 percent at the end of 2017.”⁶
The Story Investors Love
According to behavioral scientists, good stories sell. Knowing this, plan sponsors promote target date funds using two stories that investors have bought into hook, line, and sinker…
#1) Younger employees can tolerate bear markets better than those closer to retirement because they have a higher tolerance for risk and more time to recover their portfolios.
#2) Investors in their 50s and 60s can’t afford a stock market crash and risk losing a chunk of their savings.
Investors buy into these stories, making target date funds a logical, smart choice for their retirement future.
However, according to Arnott, these two beliefs are doing more harm than good to investors. “Target date funds start out too aggressive and finish too conservative, when you have the money to grow,” says Arnott.⁷
The Default Option
Another factor that may be contributing to target date fund popularity: most companies’ 401(k) plans use target date funds as their default option, or Qualified Default Investment Alternative (QDIA).
The Pension Protection Act of 2016 enabled employers to direct plan participants’ assets into a target date fund and not be liable–should the employee not select an investment.
According to the Department of Labor, 97.6% of retirement plans in 2016 had a target date fund as their QDIA.
Marketwatch states, “About 70% of U.S. companies automatically enroll employees into 401(k)-type plans, and more than 86% of these firms now direct people’s money by default into ‘target-date funds’ (TDFs).”⁸
And JP Morgan estimates that 88% of new retirement plan contributions are expected to be put into target date funds by this year.⁹
With so many people being automatically enrolled, as these statistics show, it’s no wonder target date funds have grown so quickly in popularity.
The fact is, there is a lack of education for investors in the financial industry, and many investors might not know they have another choice.
Potential Downside of Target Date Funds
Not All Investors Are Created Equal
Average investors are advised to invest in target date or lifestyle funds because they are supposed to automatically adjust account allocations throughout life.
So, if you’re younger and plan to retire in 2060, you’re told to select a 2060 fund. If you’re older and wanting to retire in 2030, you’d select a 2030 target date fund.
Investors are grouped solely based on their expected retirement date. This means target date funds do not take into consideration an investor’s…
- Location
- Profession
- Salary
- Risk tolerance
- Retirement goals and objectives
What target date funds say is that if you are retiring in 2040, you’re just like every other investor planning on retiring that year and, therefore, should have the same investment strategy.
Let’s look at this example: Susan and Jim are the same age and are both set to retire in 2025.
Susan has actively invested in her retirement account for over 35 years. She has a senior level position at a company she’s worked for since she was in her late 30s. She’s actively managed her 401(k) account throughout the years, and has been able to max out her yearly contribution limits for the past few years.
Susan’s biggest concern right now is protecting her money this close to retirement.
Jim has also been saving for 35 years, but he has worked for 4 different companies and is in middle management. He has had debt troubles over the years, and hasn’t been able to maximize his retirement savings.
Jim is focused on making up for lost time and wants to be more aggressive so he ends up with more money at retirement.
Susan and Jim are very different investors. Based on their situation and goals, does it make sense that they are in the same investment strategy?
No!
Appropriately Managing Downside Risk
A recent article indicated that, on average, target date funds invested 75% in common equity, generating average losses of over 30% during the 2008 financial crisis.
Investors planning to retire in 2010 suffered significant losses because 2010 target date funds increased their common equity exposure in 2007.¹⁰
The reality is that target date funds will often underperform in good markets and do a poor job of managing downside risk during tough markets.
According to Morningstar analyst Jeffrey Holt in March 2018…
“In the long run, the biggest risk in target-date funds is that they won’t meet
investor expectations for avoiding losses.”¹¹
Another problem is that target date funds do not take into consideration changes in economic and market trends or in other things that could change, such as tax or trade policy.
They may not make adjustment for any of these driving factors that affect investment performance.
Potentially Maximize Your Retirement Savings
Although you might have basic investment knowledge or are invested in a target date fund, we recommend reaching out for third-party advice.
Utilizing an expert for help with investing and allocating your 401(k) or other workplace retirement account could change the performance of your account from good to great.
In fact, a Morningstar report shows that participants that received expert guidance had as much as 40% more income during retirement versus those who received no help at all.¹²
If you think you’re too close to retirement or don’t have enough money saved, don’t let that stop you.
It’s never too late to take control of your financial future! If you’d like to know How to Supercharge Your 401(k) Performance, download our no-cost guide today.
Sources:
- MarketWatch, Opinion: Target-date funds are more expensive and less effective than this simple investment plan, February 20, 2019
- MarketWatch, Opinion: Target-date funds are more expensive and less effective than this simple investment plan, February 20, 2019
- MarketWatch, Opinion: Target-date funds are more expensive and less effective than this simple investment plan, February 20, 2019
- Vanguard, How America Saves report, June 2018
- Vanguard, How America Saves report, June 2018
- Bankrate, Autopilot Investing: The pros and cons of target-date funds, Bankrate, September 2018
- MarketWatch, Opinion: Target-date funds are more expensive and less effective than this simple investment plan, February 20, 2019
- MarketWatch, Opinion: Target-date funds are more expensive and less effective than this simple investment plan, February 20, 2019
- Why Target Date Funds Dominate The 401(k) Market, Forbes, June 2018
- The Global Financial Crisis and the Performance of Target-Date Funds in the United States – October 1, 2011
- Special Report: Fidelity puts 6 million savers on risky path to retirement, Reuters.com March 5, 2018
- Special Report: Fidelity puts 6 million savers on risky path to retirement, Reuters.com March 5, 2018
