By Jane Young, CFP, EA
Target date funds (TDFs), also known as life cycle funds, have become a popular choice for those investing in 401k and 403b plans. Currently there are over forty million people invested in TFDs totaling over 2.5 trillion dollars. They provide a managed portfolio for investors who are uncomfortable managing their own investments or who chose not to hire a financial planner. It is an uncomplicated way to invest in a diversified portfolio. You specify a target retirement date, and the fund systematically rebalances your portfolio as you approach retirement. They are designed to gradually reduce risk by decreasing your allocation in equity over time.
TDFs are a mutual fund that holds a variety of index funds usually provided by a single fund company. Most TDFs contain mutual funds representing several types of assets including domestic, international, large, medium, and small stock funds along with bond funds.
TDFs are a convenient way to invest and rebalance your portfolio but there are several drawbacks. TDFs are based solely on your target retirement date. It is one size fits all without consideration for your risk tolerance, financial situation, or financial goals.
A study published by the National Bureau of Economic Research in 2021 found that TDFs are inappropriate for many investors, especially as we age. TDFs change the allocation in equity over time and this is known as the glide path. The allocation in equities at 90% early in our career was found to be appropriate. However, the gradual decrease in the equity allocation to 50% as we reach retirement and down to 30% as we move through retirement was too conservative. Based on the model used in the study, the average recommended equity exposure should never fall below 60% in equities.
This study also concluded that there is a loss in purchasing power associated with investing in a TDF rather than investing in an optimal portfolio, reflecting your individual situation. On average they discovered that investing in a TDF resulted in an annual loss of 1.7% in purchasing power in comparison to an optimal portfolio.
Another drawback is the allocation used in TDFs does not consider assets held outside the fund. Most investors have bank accounts and investment accounts outside of their employer’s retirement plan. All assets should be taken into consideration when rebalancing your portfolio. Additionally, TDFs are designed to be the only investment option selected within a retirement plan. Most investors invest in several stock mutual funds, in addition to the TDF, which may result in a portfolio that is out of balance.
Furthermore, the fees on TDF’s are more expensive than index funds offered within the retirement plan. The average fee for a TDF is about .50% in comparison to the average fee for an index fund of less than .10%. In general, TDF’s are limited to one fund family. You do not have the option to select funds from a variety of fund families including those who may specialize and excel in specific categories.