Allworth Co-CEO Scott Hanson offers some pros and cons of using target date funds in your investment portfolio.
Are you familiar with target date funds?
I can’t help but enjoy saying the phrase, “target date funds,” even if they aren’t ideal for everyone.
Because when it comes to target date funds, as with so many catchy phrases and tag lines, sometimes the packaging outshines what’s inside.
But, first, what are they?
A target date fund is a type of mutual fund (or exchange-traded fund) that is positioned in such a way as to (ideally) peak at a pre-selected point in the future. They are a relatively straightforward, one-size-fits all approach to investing, and their rebalancing is based on your age and proximity to retirement, so they generally (and automatically) become more conservative over time.
Now there are two kinds of target date funds: target date and target risk.
Target date funds adjust future investment rebalancing based on the year in which you plan to retire. Conversely, target risk funds typically provide you with three levels of investment risk tolerance to choose from.
Here are some pros and cons of target date funds.
Pro: They are the default option for employer-sponsored 401(k) plans with automatic enrollments
But of course they are.
An increasing number of people are having their 401(k)s professionally managed by an advisor. But, especially early in your career, if you accept a position with a company that sponsors a defined contribution plan, say, a 401(k), 403(b), or 457, and you are automatically enrolled in their retirement plan, you may initially appreciate the “turnkey” aspects of having your plan contributions invested in a target date fund based on the year in which you intend to retire.
Target date funds in retirement plan accounts are usually simple and offer a comparatively limited number of investment options.
Con: Just because it’s simple doesn’t mean it’s less expensive
Since each fund is a “fund of funds,” consisting of multiple underlying mutual funds, more automatic trading typically occurs in target date funds than with indexed funds.
On top of fees for trades, you may also be paying both an ongoing fee for the fund and an ongoing fee for the management of the fund.
And that means, depending on who you work with, you might be paying more than you would for other comparable-but-more-versatile investment vehicles.
Pro: Some people appreciate fewer choices and a conservative investment approach
Target date funds are sometimes referred to as “set it and forget it” investments. If you plan to retire in 2035, that means you pick a fund with “2035” in its name, and that fund will automatically rebalance to an increasingly conservative allocation the closer you get to your estimated year of retirement.
If a person’s main consideration is asset preservation and simplicity, a target date fund could be a viable option.
Con: Age is often the primary consideration of target date funds
When you work with a fiduciary advisor, you not only get holistic financial planning and investment management, including proactive and responsive guidance, you work together to identify your investment preferences and allocations based on your personal risk tolerances, your short-and-long-term financial goals, changes in your life, preparing for emergencies, big purchases, and a host of other possibilities and outcomes.
The dominant driver of target date funds is a person’s age and proximity to retirement, not their personal preferences or other internal or external economic concerns. Simply, they treat all 57-year-olds (or 59-year-olds, or 63-year-olds...) exactly the same. This could result in an allocation that is both too conservative and not varied or responsive enough for some investors. And so, without professional financial guidance, along with a mix of other investments, that could conspire to leave you short of your retirement goals.
As a reminder, this is merely a general overview of target date funds. You should speak with your advisor if you have any questions or concerns about them. Investment management is complex, and target date funds certainly have a place in some portfolios.
As with all financial planning and investment management considerations, the final decision depends on your unique situation and what your ultimate financial goals are.