Target Date Funds have been increasing in popularity and are offered broadly within 401k and 529 plans.  The money flow into these funds has continued to soar, primarily due to the ease and simplicity they offer investors who may be unsure of where to direct funds within these plans. Many 401k plans now default to target date funds if the participant doesn’t choose an investment. 

The name Target Date Fund (TDF) is based on the idea that money is invested with a target date in mind: when an investor will need access to the funds.  For 401ks this is typically the year of retirement or for 529s, the year a child goes to college.  They offer the investor automatic rebalancing and a pre-selected mix of stock and bond funds. The target date fund invests in various mutual funds with percentages dedicated to equity and fixed income that gradually shift as the fund approaches the target date.  The shift from stocks to bonds over time is called the target date fund’s glide path. The equity is typically high in the early stages when the target date is far away.  The fund then automatically shifts the allocation to favor fixed income and cash, so that funds are more conservatively invested as the target date approaches.

This autopilot approach simplifies investing and eliminates the need for continuous monitoring and rebalancing.  

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Although they may be simple and automatic, TDFs come with several disadvantages of which investors need to be mindful. 

Systematic Reduction of Equity.  The underlying approach to all TDFs is that they automatically reduce equity exposure as the target date nears.  During the financial crisis in 2008 the S&P 500 dropped 37% peak to trough without regard to a calendar year. Equity investors incurred large losses. In the following years, if they had remained invested in stocks they would have recovered much of these loses, yet investors in a TDF had their equity allocation continually reduced.  This then decreased the opportunity for their investment account to recover as the market rebounded.  

TDFs follow the one-size-fits all approach.  TDFs can be a good fit when retirement is far-off, but there are many factors to consider along the way:  total value of nest egg, financial commitments and medical issues to name a few. As investors approach retirement the financial picture becomes more complicated and they are more likely to need customized financial management.

Inconsistency of Returns.  Investors will see varying returns for funds with the same target date.  This is because the underlying asset mix varies greatly from one fund manager to another.  As mentioned, most funds start out with a high equity allocation, but as the target date nears, the disparities among TDF glide paths become great.  Some TDFs will take the equity allocation down to 20% over time while others will only lower it to 60%.  

No Guarantee.  There is no guarantee that investors won’t lose money just because this critical end date is near.   Performance is particularly varied during extreme market conditions. In 2008 many funds that were close to their target date took large losses when in theory they should have been invested very conservatively with a percentage of the money held in cash.  

Overall Asset Allocation.  Asset allocation within the TDF is continually changing.  Not only does it shift according to the fund’s stated glide path, but the manager can also make adjustments to that glide path and to the underlying investments.  Transparency is lacking and it can be difficult to determine the specific exposure a fund has to riskier assets. A high allocation to fixed income doesn’t always mean the fund is conservatively invested.  These holdings could be emerging market or high yield bond funds which have a high correlation to stocks.  

Use of Mutual Funds.  Another drawback of using a target date fund is that the underlying investments are mutual funds as opposed to direct holdings of stocks and bonds. Although taxes are not an issue in a 401k or 529, if a TDF is owned in a taxable account, mutual funds give the investor little control. Holders of mutual funds inherit the tax basis of the fund. When using a customized portfolio of direct holdings, the investor controls the fund turnover.  Gains and losses are realized at a time that is most beneficial to the investor’s unique tax situation. Portfolios are likely to have duplication of positions particularly when you hold funds in a TDF in addition to holding mutual funds in other accounts. Portfolios become over diversified and lack focus. 

Fees.  Fortunately, fees have come down on TDFs since they were first introduced.  However, they can still vary greatly from one plan to another. Funds that use only index funds in the underlying investments can be very low cost, some below a .20% expense ratio.  Others that use actively managed funds may have fees exceeding 1%. Most importantly, some managers will charge more for a fund that is part of a target date portfolio versus purchasing that same mutual fund outright.  Typical 401k or 529 plans will offer TDFs but will also offer single mutual funds outside of the TDF. Consider the fees for each to determine whether the TDF truly makes sense.

Note:  Donna St.Amant, MBA, is Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit. Visit us at  ptview.com.

For over 25 years, Point View Wealth Management, Inc. has been working with families in Summit and beyond, providing customized portfolio management services and comprehensive financial planning, to develop and achieve their financial goals.  Click here to contact David DietzeClaire TothDonna St.Amant, and Elaine Phipps, or call 908-598-1717 to learn more about Point View Wealth Management, Inc. and how we can help you and your family meet your financial objectives. To sign up for our complementary commentaries and newsletters, e-mail us at firm@ptview.com.

CNBC has named Point View one of the Top 100 fee-only wealth managers in America.