Target-date funds have become a hot commodity, especially among 401(k) savers. Investments in target-date funds reached 20 percent of assets in 2015, according to joint research from the Employee Benefit Research Institute and the Investment Company Institute.
Millennial investors are increasingly steering towards these funds on the job. The EBRI/ICI data shows that 47 percent of 20-somethings are invested in target-date funds through a workplace retirement plan. At the end of 2015, 60 percent of recently hired 401(k) participants held target-date funds, which accounted for more than a third of their assets.
Target-date funds are often an easy choice for investors who are embarking on a career and don’t want to the burden of building a portfolio on their own, says Jason Laux, vice president of Synergy Group in White Oak, Pennsylvania. “Millennials like the simplicity of a target-date fund because it’s a hands-off approach for someone just starting to build their retirement nest egg,” he says.
[See: 7 Tips for Finding the Best Target-Date Retirement Funds to Buy.]
These funds start you off with one asset allocation, based on your retirement date, then adjust to become more conservative as you get older. Essentially, they take the guesswork out of choosing an ideal asset allocation and remembering to rebalance.
From that perspective, target-date funds can be a good entry point into investing for beginners who want to set-it-and-forget-it. The question is whether they remain the right choice for the long haul.
Cost. Fees are often one of the stealthiest threats to your investments. According to a NerdWallet survey, millennial investors who pay 1 percent in fees annually could sacrifice $590,000 in returns over a 40-year career. That’s a significant amount of lost retirement wealth.
If you’re investing in target-date funds through an employer’s retirement plan, it’s important to consider how the cost compares to other fund options. According to ICI, target-date fund expense ratios averaged 0.51 percent in 2016, with expense ratios falling by 24 percent since 2008. That doesn’t mean, however, that target-date funds are always a better bargain. For instance, expense ratios for index equity mutual funds averaged just 0.09 percent in 2016 by comparison.
Daniel Kern, chief investment officer for TFC Financial Management in Boston, says it’s critical for younger investors to know the details before investing in target-date funds. He points out that many target-date funds are funds of funds, meaning they invest in other mutual funds and may be more expensive. According to ICI, 97 percent of target-date funds are funds of funds. The average expense ratio for those funds was 0.66 percent in 2016.
Additionally, Kern says many target-date funds cater almost exclusively to actively managed funds versus passive investments. That in turn can trigger higher fees, which can diminish more of your returns over time.
If you’re already investing in target-date funds through your 401(k), take a second look at your expense ratio. Then, consider what you’re getting in the way of returns to determine if the fees are justified.
“Ask yourself what does this target-date fund cost every year and is that acceptable for the benefits it provides,” Laux says.
Market conditions. Target-date funds are designed to adjust, based on your individual timeline for retirement. A significant drawback is that they don’t account for fluctuations in the market. Laux says that target-date funds may move you into asset classes that aren’t appropriate for the current economic climate.
For example, when interest rates rise, bond prices fall. In a rising-rate environment, a target-date fund that’s getting closer to your target retirement age would automatically move toward bonds and other more conservative investments, without considering the full impact to your portfolio.
[See: The Top 10 Investment Portfolio for Millennials.]
Chris Battreall, managing director at United Capital in Modesto, California, says the same thing that makes target-date funds so appealing to younger investors is also their biggest downside. While these funds offer instant diversification, they mistakenly treat your retirement date as the finish line. “The problem is that retirement isn’t the finish line — death is,” says Battreall, and you run the risk of having your investments underperform as your asset allocation changes.
He says this flaw with target-date funds starts to become more evident as you move into your 40s and 50s. As the glide path or investment allocation of the fund changes, investors must reevaluate whether the fund is still steering them towards their objectives. Beginning around age 40, you may be better served by a more individualized investment mix that takes your time horizon and goals into account.
As you move into your 50s, you need to understand that “target-date funds aren’t able to maintain a high allocation to stocks, even if the market is doing great and you’d refer to stay invested in equities,” Battreall says. “They just aren’t designed that way.” You need to understand what you may be sacrificing in returns in exchange for the convenience target-date funds offer.
Risk. Target-date funds simplify investing in many ways but they can complicate it if they get your risk exposure wrong, says Chuck Mattiucci, senior vice president and financial consultant at Fort Pitt Capital Group in Pittsburgh.
Investing isn’t one-size-fits-all and everyone’s situation is different, Mattiucci says. Target-date funds tend to be more cookie-cutter and they don’t take into account where you fall on the aggressive or conservative scale. Choosing a target-date fund based solely on your expected retirement date could leave you with an investment that exposes you to too much — or not enough — risk to meet your goals.
Jake Gilliam, senior multi-asset class portfolio strategist at Charles Schwab Investment Management in the Cleveland area, says determining risk tolerance can be challenging for younger investors who haven’t had much experience with market cycles. He says this is why understanding a target-date fund’s glide path is important. He says some target-date funds manage your assets to retirement, while others manage it through retirement. That can make a difference in how your allocation changes over time and in turn, affect the rest of your retirement portfolio.
If you’re not sure what your true risk tolerance is, ask yourself how your past experiences with the market have shaped your decision-making. Laux says how often you check your investment performance can be an indicator of how comfortable you are with risk, and whether a target-date fund makes sense.
“Some people look at their performance every day and others never open their statements,” he says.
[See: 12 Terms Every Investor Needs to Know.]
If you’re constantly checking your investments, that may be a sign that you have a lower risk tolerance than you realize. Ultimately, he says “your risk tolerance has to match your comfort level to avoid poor investment decisions.”
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Target-Date Funds Are a Bad Choice for Older Investors originally appeared on usnews.com
