You’ve seen them in your 401(k) options. You might even be invested in one now but do you know what they are & how they work? A target-date fund is an investment fund that “targets” a certain year for retirement. For example, your retirement account may have a XYZ Target Retirement Fund 2035, 2040, 2045, & so on.
The reason for their popularity & widespread use is simple, simplicity. Many employees pick these funds when they sign up for their 401(k) plan & think this fund will get them there. What could go wrong?
In order to properly understand the hidden dangers of a target-date fund, you need to understand what they do.
The core idea behind a target-date fund is asset allocation. Someone who is younger, and has more years until retirement, can theoretically handle more stocks in their portfolio. A person retiring in 2040 might have anywhere from 50% to 60% in stocks. As that person gets older, the stock portion might decrease to as little as 25%, depending on the fund.
This automatic re-balancing can make life easy for the employee.
The Cries from 2008
The Financial Crisis in 2008 showed us that target-date funds are not the perfect retirement solution that we once thought them to be. This was especially true for those on the cusp of retirement. Many didn’t understand the level of risk & volatility that was in their current portfolio. When the 2008 crisis hit, many of those “conservative” funds, lost and average of 22% or more. When you’re retiring within a month & you need to start withdrawing income, that poses a serious problem.
A target-date fund is a fund that is invested in other funds. This additional layer creates brings added cost to the table. The average charge for a target-date fund is 0.73%. The average stock fund charges 0.68%, and the average bond fund charges 0.54%. In a 60% stock – 40% bond portfolio, the average target-date fund charges almost 17% more than a properly constructed portfolio.
What’s in the Bag?
Because of the complexity of target-date funds, it is often incredibly difficult for a non-professional to understand what the fund really is invested in, not to mention time consuming. The difficulty of knowing what you’re invested in doesn’t excuse the need.
How much of the fund is in large-cap stocks? What about mid-cap or small cap? Is the international portion large cap, small cap, or emerging markets?
What about the bonds? In the next few months, I’ll cover the current bond conditions in more depth; however, it is important to know that many of the target-date funds are using bond funds that I would not find suitable for my clients because of the underlying risk vs reward.
The investment style and asset allocation is a major part of investing for retirement. If you’re not properly allocated, then chances are your portfolio is going to under-perform and/or you’re going to be subject to too much risk.
Do your homework
Or like a lot of the kids in school, pay someone to do the work for you. Regardless of how it gets done, research much always be done to understand what your invested in. The fund’s prospectus needs to be read. The investment style needs to be understood. There’s simply too much money at stake. An inefficient retirement portfolio can end up costing you tens of thousands to hundreds of thousands of dollars by the time you retire.
The majority of the time, a properly allocated portfolio will be more efficient than a target-date fund. There are times when a target-date fund is appropriate; however, that is more the exception than the rule. Whether or not a target-date fund is right for you, you should think twice about using them. After all, you might simply be leaving a lot of money on the table.