3 Pros, 3 Cons of Target-Date Funds

One of the most popular investment vehicles offered in the average 401(k) plan is the target-date fund. As a passive investment, target-date funds are intended to provide retail investors with a one-size-fits-all diversified portfolio of equity, fixed-income and cash assets.

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The goal of a target-date fund is to ensure an appropriate, lifelong risk-return profile for hands-off investors. Target-date funds achieve this through asset allocation, which is the process of how the fund chooses which assets to hold and in what proportions relative to each other over time.

As investors grow older and approach retirement, their time horizon gets shorter and their risk tolerance declines. A target-date fund therefore adjusts its holdings on a periodic, automated basis to reflect a more conservative asset allocation, such as increasing bond and decreasing stock holdings.

The rate at which a target-date fund changes its asset allocation strategy to become more conservative is known as a “glidepath.” For example, a 2055 target-date fund would be suitable for investors planning on retiring in the year 2055, 33 years from now. Right now, this fund might be 90% in stocks and only 10% in bonds. In 20 years, the same fund might be 60% in stocks and 40% in bonds.

Target-date funds are one possible way to invest for retirement aside from advisor-managed, robo-advisor or self-directed portfolios. While they’re often promoted as a suitable, hands-off choice for most investors, there are both pros and cons to target-date funds. Here’s what the experts say:

— 3 pros of target-date funds.

— 3 cons of target-date funds.

3 Pros of Target-Date Funds

Simplicity. The biggest advantage of a target-date fund is simplicity. Brian Huckstep, chief investment officer at Advyzon Investment Management, considers them “a godsend for investors who have absolutely no knowledge about investing, who might otherwise make significant portfolio allocation mistakes.” For example, investors don’t need to worry about rebalancing annually or changing holdings as they get older; nor do they need to spend excessive time researching stocks and investment strategies. With target-date funds, all that’s needed for building wealth is a passive buy-and-hold mentality with consistent contributions.

Tinkering prevention. The all-in-one nature of a target-date fund also prevents excessive tinkering, which can drag on investor returns from excessive trading commissions and portfolio turnover. Think of an investment portfolio like a bar of soap — the more you touch it, the smaller it gets. Target-date funds force investors to stay hands off and minimize behavioral sources of risk like chasing past performance, panic selling, attempting to time the market or rotating into hot stocks or sectors.

[Read: How to Build an Investment Portfolio]

“Studies of dollar-weighted returns have shown that target-date funds produce higher returns than the average DIY investor who builds their own investment portfolio,” Huckstep says. “Individual investors tend to be jumpy, exit investments at the worst time after a pullback, or hold onto investments too long after prices become inflated. The long-term discipline of target-date fund managers, who rebalance periodically by selling overweight positions and buying underweight positions pays off in the long run,” he says.

Low expense ratios. Benjamin Koval, investment advisor at SoundPath Retirement Strategies, notes that another big advantage to target-date funds are their low expense ratios compared to actively managed funds. This is an annual fee, expressed in percentages that are deducted from the net asset value of the fund. For example, a target-date fund charging 0.1% per year would cost $10 in fees for a $10,000 investment.

“Fees are an easily controllable source of risk and drag on performance,” Koval says. Keeping fees as low as possible can boost returns significantly due to the power of compounding. This is especially acute for investors with larger portfolio sizes, where small increases in expense ratios can amount to significant opportunity costs further down the line.

3 Cons of Target-Date Funds

Flawed assumptions. However, the generalized, one-size-fits-all nature of target-date funds can leave investors exposed during unusual economic conditions. Rick Lear, chief investment officer at Lear Investment Management, notes that “target-date funds are based on the premise of static asset allocation, which assumes bonds are always less risky than stocks. This is not the case in a period of rising inflation and higher interest rates.”

The flaws in this assumption have played out in 2022, when historically conservative fixed-income assets cratered alongside a rapid series of interest rate hikes. Target-date funds often lack an allocation to alternative assets that perform well in a rising rate, inflationary environment, such as commodities, managed futures or long volatility instruments.

Not seeing the whole picture. Robert Johnson, chairman and CEO at Economic Index Associates, argues that another downside of target-date funds is their inability to consider the investor’s holistic wealth circumstances. “Target-date funds use one variable — a person’s expected retirement date — to guide the construction of the portfolio,” he says. “However, a person’s assets outside of the target-date fund (real estate, insurance policies, Social Security, etc.) should also be factored in when designing an appropriate portfolio.”

Daniel Kern, chief investment officer at TFC Financial Management, agrees with Johnson, stating: “As mass-market products, target-date funds are designed to create a uniform experience for most investors.” Kern is in favor of a more comprehensive investment planning approach that, in his words, “identifies investor resources including assets, liabilities and projected savings, and matches them against the future goals and resources required.” For investors with more complex needs and assets, the simplicity of a target-date fund might be inadequate.

Occasionally opaque fee structure. Finally, Huckstep notes that although most target-date funds have low expense ratios, there are some with less-than-transparent fee structures. “Target-date funds have two layers of fees — a management fee, and a fund-of-funds management fee,” he says. Together, these fees are added together and reported as an overall expense ratio in the fund’s prospectus.

However, fund companies are allowed to only report the fund-of-fund management fee in the annual report. “A common strategy is for some disingenuous target-date funds to charge high fees in their underlying funds, and then very low or even zero fees at the fund-of-fund level, allowing them to legally promote misleading fees in their annual reports,” Huckstep says. This can be misleading for novice investors who rely on inaccurate third-party sources that do not pick up on this distinction. Huckstep cautions investors to review the fund’s prospectus carefully, and be wary of any hidden or “wrapped” fees charged, including potential front- or back-end loads.

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3 Pros, 3 Cons of Target-Date Funds originally appeared on usnews.com

Correction 08/16/22: A previous version of this article misidentified the name of the company Brian Huckstep works for. Brian Huckstep works for Advyzon Investment Management.

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