Are Target Date Funds a Good Idea? Here's Why You Might Want to Rethink Yours
Think a target date retirement fund (lifecycle fund) offers the best way to zero in on the right retirement savings strategy? Maybe not. Let's find ou...
It's easy to become overwhelmed by all your investment options, especially when the plan administrator at your job says, "Take a look! Lucky for you, we have so many investment choices available!"
Do you really have time to research Morningstar, compare and contrast fees, holdings, asset allocation, performance over time, sectors and more?
Instead, you may think, "Gosh, it sure would be easier just to pick something already geared toward my retirement age."
Target date funds are ready-made for that exact situation. But are they all they're cracked up to be? Let's find out.
What is a Target Date Fund?
When you choose a target-date fund, you pick a fund with a target year closest to the year you anticipate retiring. For example, you might choose something called a "2045 Retirement Fund." As you get closer to your target retirement date, the fund reduces your risk by slowly changing your investments. In other words, you pursue a long-term investment with a specific asset allocation. This asset allocation adjusts from a focus on growth in the beginning and turns into a more conservative approach as you get closer to your target date.
Investing in target date funds continues to grow in popularity. According to a 2018 study by the Investment Company Institute, 26.6% of 401(k) assets in the EBRI/ICI 401(k) database were invested in target date funds, up from 25.3% in 2017.
A total of 50.5% of 401(k) assets were invested in target date funds at year-end 2018 among plan participants in their 20s. On the other hand, only 22.9% of people in their 60s had 401(k) assets invested in target date funds.
Reasons to Rethink a Target Date Fund
You may decide to choose a target date fund, also called a lifecycle fund, but here's why you might want to rethink the idea.
Reason 1: Investing in other funds alongside your target date fund can change your asset allocation.
Let's say you get so comfortable with investing that you choose to invest in other funds alongside your target date fund. This can mean your asset allocation completely changes.
For example, let's say you choose to invest half of your 401(k) assets to a target-date fund and then also choose to invest the rest of your retirement funds toward stocks. You could drastically change your asset allocation, thinking you're diversifying yourself. However, a target date retirement fund (which is usually made up of a number of funds) already properly diversifies you because it aligns with your target retirement age. Adding to it could really skew your results in the long run.
Reason 2: They don't account for your entire financial picture.
Target date funds by themselves can't possibly take your financial picture into account. For example, let's say you have a pension from a previous job or other retirement savings, such as a Roth IRA or other investments. In some situations, it may make sense to consider a pension as part of your fixed income allocation. Otherwise, you might be invested more conservatively than you’d like.
It's a good idea to take a total view and account for your other brokerage accounts and other IRAs by looking at them as one giant portfolio. You may want to ask a trusted fiduciary financial advisor to help you manage the investments in your 401(k) plan so this person can advise you with a comprehensive view of your assets.
Reason 3: People are more complex than target dates.
You may have more needs than what a target date retirement fund offers. For example, maybe you actually have a lower risk tolerance than what a fund "thinks" you'll "need" in your early years. In the early years of a target date fund, it'll put a large slice of your portfolio into growth stocks rather than traditionally safer fixed-income investments like bonds.
Let's say your neighbor has savings from an early pension. He may have enough money to readily accept bonds and other fixed-income securities at the end of his target retirement fund.
On the other hand, you may need equities to keep your portfolio from running out of steam before the end of your life. Target retirement funds assume a lot about you and don't actually make an effective one-stop-shop for absolutely everyone's needs.
Reason 4: You might change your retirement date.
Target-date funds lock you into a specific risk level based on your assumed retirement date. Most funds also assume you'll retire around 65. When it grows more conservative, a lifecycle fund assumes that you'll need money for 20 to 30 years. However, what if you'll actually need money for longer because you decide to retire at age 50 or age 55? There's no question about it: Age-based allocations could miss the mark, especially if you choose to retire earlier than you'd originally anticipated.
Reason 5: You May Miss Out on Cheaper Options (or Better Options)
You (or you and your advisor, together) may get you closer to your ideal investment mix and the asset allocation you need. You and your adviser might be able to work together to reduce the amount you spend per year on your investments. Carefully consider your overall risk and return, in addition to how much you spend on your particular plan. Consider all the angles before you jump into a target date or lifecycle fund, and remember that active management usually costs more than passive management.
Make the Right Decision Early On
Target date or lifecycle funds can offer you an easy selection process on your way to saving for retirement. You can tap into many options, whether you opt for active or passive management and an asset allocation that meets your specific age-based needs. However, rather than blindly choosing a particular target date retirement fund, you need to take a look at asset allocation, fees and risk tolerance, among other things.
Naturally, it's best if you make the right decision about whether a retirement plan makes sense for you early on in your career. However, remember that you can always pivot later if your target retirement fund no longer makes sense.
Featured Article: What is a death cross?
Entrepreneur Editors' Picks
How Millionaires Prepare for a Recession, According to a Former Wall Street Trader
5 Self-Care Habits of Every Successful Entrepreneur
Listen Closely to What People Ask You. That's Where to Find Your Hidden Power.
Gen Z Customers Want More. This 3-Step Strategy Will Help Your Company Give It to Them.
This Founder Was Madly Pulling a Pandemic Pivot When...the FBI Showed Up at Her Door With Guns, Seized Her Money and Told Her Husband He Was the Target of a Criminal Investigation
Take Customer Service to the Next Level With These Service-Based Franchises
Define Your Short-Term Goals With These 3 Components for Long-Term Success