Target Date Funds: Are They Right for You?

More and more people are investing in target date funds. The Investment Company Institute, a Washington, DC-based research institution, estimates that 41% of people who participate in an employee sponsored retirement savings plan have at least one target date fund in their plan accounts. And Casey, Quirk & Associates, an investment consulting firm, predicts that by 2020, half of all defined contribution assets under management will be target date funds.

On the surface, this rise in popularity may seem like great thing, as target date funds provide a way for people to have a professionally-managed investment vehicle with the promise of diversification and rebalancing over time.

However, as sensible as this strategy appears to be, and as popular as target date funds have become, it’s important for you to understand whether they are right for you. You should know the potential benefits and costs, and decide whether target date funds represent the best strategy for investing intelligently for your retirement.

The Appeal of Target Date Funds

A “Target Date Fund” is a mutual fund or ETF that holds equities and bonds in a proportion that’s based on your intended year of retirement. In other words, these funds offer a “glide path” – an allocation between equities and fixed income securities that changes over time as you approach retirement.

For example, a “Target 2020 Fund” would hold a large portion in conservative investments such as bonds and cash equivalents. It would be designed to preserve wealth rather than chase growth.

A “Target 2065 Fund,” on the other hand, would hold more aggressive investments.

Target date funds have an understandable appeal: they claim to make your life easier. You don’t need to calculate how much to allocate to U.S. large cap or international stocks, or short-duration bonds, because the target date fund does it for you.

One Size Does Not Fit All

One of the biggest shortcomings of target date funds is that they assume everybody who plans to retire in the same year has the same retirement goals, the same attitudes about investing and risk, the same tax profile, and so on. The funds base their formulation on observed average investor preferences for different age groups and lifecycle phases.

But that’s like saying that the average 30-year old American male has size 10 shoes, so every 30-year old American male should wear size 10, regardless of his actual shoe size.

Your retirement circumstances are not the same as everyone else your age.

For example:

John and Mary are both 45. They’re conservative investors who feel anxious when the market drops. They despise seeing losses in their portfolio, and they’ve occasionally sold off equities in a panic during bear markets. They want to retire at age 65, which will be in the year 2035.

**

Zeke is 27. He’s an aggressive investor on the fast-track to an early retirement. He also wants to retire in the year 2035 — when he’ll be only 48 years old.

In order to retire at such a young age, Zeke is willing to save a large percentage of his income and invest aggressively. And he realizes that in the worst-case scenario–if his aggressive investments don’t perform as he hoped– he can always keep working until 2040 or 2045.

**

Karen is 55. She hasn’t saved much for retirement yet. She’s getting an ultra-late start, and she realizes that, at her age, she should not invest more aggressively in order to compensate for lost time. Her only path towards a secure retirement involves working more — and saving more. She’s hoping to retire in 2035, when she’s 75.

As you can see, these three hypothetical characters share a common thread: they intend to retire in the year 2035. But their age, life circumstances, and attitudes towards risk point them towards very different asset allocation strategies.

Appropriate Diversification Across All Accounts

Another limitation with target date funds is that most people do not understand how to consider target date funds in the context of all the investment options within their 401k plan and with any other holdings they may have with other retirement accounts.

When you choose a target date fund for your retirement plan, you are basically deferring your retirement portfolio asset allocation decision to the target date fund manager. And you don’t want to have other single asset class funds in the mix. In fact, doing so could be disadvantageous, as it may give you more exposure than you should have to some asset classes and less to others.

For example: Let’s say an investor has one 401k account, a Roth IRA and two taxable brokerage accounts. These accounts are held at different financial institutions.

The investor puts some of her money within a target date fund. But she also puts some money into an S&P 500 fund, she buys a few emerging markets funds, and she dips her toes into a few commodities funds.

How can she know if she’s allocating her assets correctly?

Furthermore, notice that her funds have different tax structures: She holds tax-deferred, tax-exempt and taxable accounts.

She’ll want to weigh her tax treatment when she’s deciding which accounts should hold various types of assets. For example, she may want to hold tax-exempt municipal bonds in one specific type of account.

But target date funds don’t weigh these different types of tax treatments.

What’s the solution?

Option #1: You could hold only one brokerage account, keep all of your retirement savings in that single account, and invest that in a target date fund. But this option has plenty of drawbacks. First, you can’t diversify your money between tax-deferred and tax-exempt accounts. Second, target date funds (as we discussed above) don’t allocate your assets in a way that’s uniquely suited to your personal situation.

Option #2: Rather than investing in a target date fund, you should invest in a diversified range of equities, bonds and other assets. Use an online service, like Jemstep’s Portfolio Manager, to create an investment plan that’s custom-tailored to your unique situation.

You see, the fundamental problem is that a target date fund is a managed portfolio, which is held inside of your entire portfolio. But the rest of your portfolio contains other investments.

You should manage your entire portfolio as a whole — not each chunk of your portfolio, piecemeal. This will allow you to optimize for tax efficiency, maintain your asset allocation, and rebalance with greater ease.

Technology is Changing the World

When target date funds first came out, they filled a clearly understandable need: to help individuals with minimal financial knowledge invest for retirement.

In more recent years, however, other approaches have appeared on the scene that offer remedies for some of the shortcomings with target date funds. With developments in technology and new online services the world of retirement investing has changed.

Jemstep Portfolio Manager is one such approach. Portfolio Manager is an online investment advisor that gives you personalized, unbiased advice on how to invest your 401k and other accounts. It provides a recommended asset allocation and advice on where to locate your assets to obtain maximum tax and other benefits. It then evaluates and recommends fund selections using an advanced portfolio optimization technology across multiple characteristics and attributes.

Americans need to save more for retirement, and target date funds were developed to help facilitate better investing habits. But before deciding to go the target fund route, you should understand their potential shortcomings and be aware of the alternate services, which may help you create a more secure retirement.