I remember the first time I signed up for a 401(k) at work.
Although I had invested in individual stocks and mutual funds, I wasn’t familiar with any of the options my 401(k) offered. I needed to pick something though, and I didn’t want to go with cash. The paperwork was due.
I chose the easy option: the target-date fund.
Target Date Funds: The Basics
Target-date funds are one of the most common 401K options, often at the top of the list of available investment options as you scroll through. They have been particularly attractive to younger investors. Over half of Millennials hold assets in a target-date fund, according to Elaine Sarsynski of MassMutual.
While you can buy and hold a target-date fund in any investment account, the vast majority are held in 401(k)s.
The theory behind a target-date fund is that by figuring out when you plan to retire, the fund adjusts its asset mix to a portfolio of investments that is right for your stage of life.
When you are young, the fund is more aggressive and focused on growth, heavy in securities. As you approach retirement, the investments become more conservative and focused on preserving capital through a greater emphasis on bond funds.
Pros and Cons
Target date funds are designed to make investing easy, putting your retirement planning on autopilot. If you put your planning on autopilot, though, are you putting yourself in the best place to weather a storm?
For a lot of people, target-date funds make investing and rebalancing funds easy. Signing up for a 401k can be intimidating, especially if you haven’t invested before. Target-date funds can make investors feel more comfortable. All the investor needs to know (or guess) is the approximate time she needs to retire.
The fund will rebalance its assets as needed. That’s a major advantage, since even experienced investors can struggle with rebalancing.
The problem is that a target-date fund is fixed to your expected retirement date and nothing else. A target date fund doesn’t adjust for your risk tolerance. You may be a more conservative young investor who becomes uncomfortable when the stock market dips. Alternately, you may be a more aggressive older investor who is willing to take more risk to get greater returns.
The funds also don’t always agree on the proper philosophy for approaching a given date. One 2036 or 2046 fund might invest far more aggressively than another company’s fund targeting the same date.
The target date fund doesn’t take into consideration any other assets you hold either. You may have other investments that make the particular mix of target date funds less appropriate to your situation, such as a brokerage account with plenty of tax-free bond holdings.
The Biggest Drawback
Those problems aren’t really too much of a problem if you are just starting out as an investor. But there’s a bigger problem to face: the mix of funds in the target date fund could include several you don’t want to own.
Some companies include funds in their target date fund that aren’t performing as well to boost the sales of the low performer. Sometimes the fund managers chose funds with higher fees. Those higher fees cut into your investment. Other fund managers will invest in new funds that need to gain traction.
In all three cases, the fund manager of the target fund was doing the best thing for the family of funds rather than what was best for the investors in the target-date funds. While this isn’t true of all target-date funds, it’s the reason some are much better than others.
Not all target-date funds are created equally. Fees can differ widely, as can their returns. In addition, some target date funds are more aggressive than others, depending on how they act as they reach the target date.
These factors have a real impact on the performance of these funds as they approach the target date.
But Better than No Plan
I didn’t stay in the target date plan too long. After a few months, I figured that there were lower cost funds in the plan that meshed better with my other investments. When I left that job, I rolled everything into an IRA where the funds went to high quality dividend stocks.
While target date funds are not the best retirement plan option for everyone, they are certainly better than no retirement plan option at all. Using a 401(k), particularly one with an employer match, is one of the best ways available to save for retirement. It offers a great return (thanks, employer match!) and tax-free growth.
For me, the target date fund I chose made signing up for that initial 401(k) just a little easier. In a blizzard of confusing paperwork, it provided a simple idea I understood to shelter behind.
If Target Date funds get you comfortable with 401(K) contributions, then that’s a great thing. Go for it. You can do a lot worse than a good target date fund, and you can always change your allocation later. Saving for retirement is always better than not saving.
For a lot of investors, though, there are better and more appropriate funds to invest 401(k) money.
How do you invest your retirement funds? Did you find that initial enrollment daunting?
This article is for information purposes only. I am not a financial advisor, but I do recommend participating in your company’s 401K plan, if you are able. Past performance does not determine future performance, and an investor should proceed with caution and do lots of research before putting their money in any investment.