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The Hidden Cost of Target Date Funds

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be wary of target date funds

If you’ve begun saving for retirement, there’s a good chance you’ve heard of target date funds. They’re a common investment vehicle, often used in employer-sponsored retirement plans like 401(k)s or 403(b)s. More specifically, target date funds are exchange-traded funds or mutual funds that are designed to target returns over a specific time frame (typically until an investor’s planned retirement), instead of ad infinitum. While a target date fund that targets your approximate retirement date may seem like a good idea, new research shows that there are often flaws in target date funds that may not make them a particularly good investment option for all retirement savers. Instead, it’s a good idea to critically examine your financial profile and retirement goals and make decisions from there. A financial advisor may be able to help you figure out if a target date fund makes sense for you. Check out SmartAsset’s free advisor matching tool to find advisors in your area.

What Is a Target Date Fund?

A target date fund is similar to an exchange-traded fund (ETF) or a mutual fund in that it is a basket of several different types of investment securities. Target date funds tend to be actively managed to produce results for a given time frame. For example, a fund with a target date of 2065 is designed and populated with investments tailored meet the needs of the investor at that date.

Because target date funds are designed around a specific future date instead of being designed to mirror an index, as is the case with many ETFs. Instead, target date funds are actively rebalanced to optimize for risk over the life of the fund. As target date funds draw closer to their target dates, they tend to become more conservative, with the equity portion of the fund decreasing and the fixed-income portion increasing, though the specific management strategy will vary from fund to fund.

Why Are Target Date Funds Popular?

be wary of target date funds

Target date funds are popular for many reasons, but one of the main draws is that like many actively managed funds, they allow investors to automate their investments without needing to cede control over to an investment professional. Someone who finds a target date fund that they like will operate under the assumption that their money is being managed with their desired target date in mind.

Target date funds are an alternative to the more hands-on and research-intensive method of choosing individual securities for your portfolio, similar to what makes a mutual fund or an ETF an attractive investment option. What makes target date funds particularly attractive compared to any other mutual fund or ETF is the fact that they’re designed with that specific target date in mind. While other funds may boom and bust over the years, target dates funds are ideally designed to be at their best at the target date.

Drawbacks of Target Date Funds

However, it isn’t all sunshine and roses with target date funds. A recent study and model created by the National Bureau of Economic Research (NBER) highlighted a number of different shortcomings with average target date funds on the market.

The model showed that optimal allocation of equities throughout the life of an average worker should follow a hump-shape distribution, peaking at 80% around age 45 and declining to 60% during retirement. However, the study found that the equity allocation in many target date funds declines to around 30% to 40% in retirement. That has the tendency to reduce a fund’s capital appreciation, something that remains important for many retirees, especially in an environment of increasing longevity and low interest rates.

The study also identified a knock-on effect of target date funds’ asset allocation, a steeper decline in purchasing power for those invested in target date funds once they hit retirement. The NBER research showed that investors in target date funds lost 1.7% to 28% of purchasing power annually, depending on how they changed other investing behaviors.

One of the biggest drawbacks uncovered in the study relates to the fact that target date funds are a one-size-fits-all solution to retirement, and retirement is anything but a one-size-fits-all life event. Two people who are targeting a 2065 retirement date may have vastly different financial situations, and a single 2065 target date fund won’t be right for both of them.

Another drawback of target date funds is the fact that they don’t typically keep up with the state of the business cycle. Reducing the allocation of equities in a fund as it gets closer to the target date certainly lowers risk — but it can also preclude the possibility of capitalizing off a bullish market and, thus, may lead to suboptimal performance in certain markets.

Bottom Line

be wary of target date funds

Much like any financial or savings instrument, target date funds aren’t right for anyone. Given the fact that they don’t take into account your specific financial situation, those managing a target date fund may not necessarily act in a way that’s most suitable to your retirement goals. Plus, the NBER study shows that allocation in target date funds may be suboptimal overall. However, if you’re thinking of using a target date fund as a way of saving for retirement, you don’t necessarily have to look elsewhere. Just make sure you understand the risk and understand your retirement savings goals before deciding to invest.

Tips for Saving for Retirement

It’s important to understand your financial situation and your retirement goals when saving for retirement. A financial advisor may be able to help you developing a savings approach that works for you. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

When planning for retirement on your own, it pays to be prepared and to have lots of good resources at your disposal. SmartAsset has you covered with a number of free online resources that can help. Check out our retirement calculator and get started today.

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The post The Hidden Cost of Target Date Funds appeared first on SmartAsset Blog.

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