How to best save for retirement is a question whose answer evolves constantly. Choosing the right investments for a retirement portfolio is an overwhelming prospect for many people. Hence, the rise in popularity of target-date funds in recent years now holds over $1 trillion in assets.
The allure of target-date funds is simple. They apply the well-accepted mantra that investors should build wealth early in their careers with riskier investments and reduce the riskiness of their portfolio as they near retirement to protect themselves from losses that could threaten their standard of living. And investors don’t have to worry about managing their investment over the years leading to retirement. Instead, they just put the money in and come back when it’s time to retire.
But are target-date funds all they are cracked up to be? It turns out that the downsides of target-date funds make them a much less attractive option than many investors believe.
How do target-date funds work?
In a target-date fund, your anticipated retirement date serves as the basis for asset allocation in the fund. The further you are from retirement, the higher the risk tolerance for the fund. Early on, funds hold a larger percentage of equities or equity funds than more conservative fixed-income investments like bonds. Over the years, the asset allocation follows what is known as the glide path towards a less risky position dominated by fixed-income instruments.
Investors have a wide range of options among target-date funds to suit their individual tastes for risk. But those investors who rely on target-date funds may be doing themselves a disservice. So before investing in a target-date fund, investors should understand the downsides.
The risk is greater than investors think
One of the main selling points for target-date funds is the reduction of risk as retirement nears. But investors who look a little more closely will see that it isn’t necessarily the case.
Consider a recent college graduate who opened an e-commerce business. They’re tech-savvy, so they use tools with crucial features such as online invoicing and payment processing to help keep track of the revenue that will serve as their retirement fund. But they aren’t well-versed in financial markets or investment, so they decide to put money in a 2060 target-date fund for retirement.
Most of the 2060 funds start with an allocation of around 90% equities and 10% fixed-income investments. The glide paths, however, can vary substantially. Many funds follow a glide path towards a 50/50 equity/fixed income split at the target date, with the split shifting more away from equities in the years following the target date. Some funds have steeper glide paths. The State Street Target 2060 Retirement Fund, for example, has only 35% invested in equities by the target date.
With as much as 50% still invested in equities at the target date, investors can suffer from the sequence of returns risk, which refers to the potential for negative returns in the last few years before retirement. For example, a substantial market downturn like the 2008 subprime crisis (DJIA down 34% for the year) or the COVID-induced market crash (DJIA down nearly 36% in 3 months) can destroy the value of the investment. And if that crash occurs immediately before retirement, the investor may no longer be able to retire if they want to enjoy the same standard of living.
Target-date funds can be a poor choice for investors given sequence-of-returns risk because they encourage investors to be hands-off concerning asset allocation, even as retirement nears. Prudent investors should be more proactive about protecting their assets from market volatility in the years immediately preceding retirement. Even if they don’t want to manage their investments personally, investors should consider alternative investments or actively manage their portfolios.
One size will never fit all
Target-date funds purport to be funding for everyone, no matter their age or financial situation. But this one-size-fits-all approach, relying simply on a date, can result in inappropriate asset allocations.
Investors need to consider their goals, along with their current and expected future financial position, to determine if the asset allocation in a target-date fund makes sense for them. For instance, investors with access to other resources to fund their retirements may want to apply a more conservative investment strategy earlier. Or perhaps they would be better off investing in other products such as annuities.
The one-size-fits-all, hands-off approach also fails to account for significant events that may occur during an investor’s life. For example, family emergencies, unexpected changes in financial situation, health concerns, and more may make the asset allocation of a target-date fund unsuitable for the investor.
Every situation is different and requires individual attention and analysis.
The funds invest in themselves
The vast majority of target-date funds invest primarily in other funds managed by the same company. According to one study, in 2019, nearly 60% of target-date funds were invested only in other funds from the same company. Another 20% invested between 50 and 99% of their assets in family funds.
Setting aside the potential conflict of interest for the moment, limiting the range of investments in this way can reduce investor returns. And because investors are passive, particularly when they are many years away from the target date, they do not provide the funds with any incentive to change their investment policies.
Fees, fees, fees
Because many target-date funds invest in other funds, investors are hit with multiple layers of fees. First are the fees that the investor pays for the target-date fund itself, which are typically lower than for actively managed products. However, the investor also bears the additional fees associated with the funds in which the target-date fund invests.
Because of the hands-off attitude most target-date fund investors take, they will not do enough research to determine the fees for the individual investments in the target-date fund, and the fund will not provide them to the investor. This lack of attention and transparency may result in investors paying far more in fees than they expect from the prospectus for the fund.
Most investors can do better
While target-date funds have a good underlying premise – growing wealth in the early years of a career and protecting that wealth in later years so that the investor can enjoy the standard of living they choose – for many investors, they won’t live up to their promise.
While those investors who simply won’t choose to allocate their retirement money may benefit, those who are willing to invest even a small amount of time are likely to find better options.