This Wildly Popular Investment Has 2 Costly Flaws

Target-date funds are as popular as ever. More than $2 trillion was invested in them as of the end of 2019.

But target-date funds are something of a one-size-fits-all approach to retirement investing. They also tend to charge higher fees than other widely recommended investments, such as index funds.

You could jeopardize your retirement savings if you invest in them blindly. So, here’s what you need to know before trusting your nest egg to target-date funds.

What is a target-date fund?

Target-date funds are funds that contain multiple types of assets and are pegged to a desired retirement date, as their name implies. For example, if you plan to retire in 10 years, you might invest in a 2030 target-date fund.

Target-date assets most commonly take the form of mutual funds.

As the target retirement date nears, a target-date mutual fund’s asset allocation rebalances automatically, theoretically sparing you the annual chore of rebalancing your own portfolio in light of your latest timetable for retirement.

This generally means that over time, stocks comprise less and less of the target-date mutual fund’s assets and bonds comprise more. That makes the asset allocation increasingly conservative over time.

In short, target-date funds are a simple way to invest your retirement savings — which makes them attractive to many folks.

Consider these recently reported numbers:

• 82% of large 401(k) plans offered target-date funds as of 2017 — up from 32% in 2006, according to the Investment Company Institute and BrightScope. Additionally, 24% of large 401(k) plan assets were invested in target-date funds as of 2017 — up from 3% in 2006.
• Target-date fund assets reached the $2.3 trillion mark in 2019, according to Morningstar.
• 78% of Vanguard retirement plan participants used target-date funds as of 2019 — and 54% of them have their entire account invested in a single target-date fund — according to Vanguard.

2 downsides of target-date funds

Target-date funds have a couple of drawbacks that anyone should consider before putting money into them:

1. Fees tend to be relatively high: The good news is that the average fee paid by target-date fund investors has been falling in recent years. According to Morningstar, it fell from 0.79% in 2014 to 0.58% in 2019.

Still, even the average of 0.58% is high compared with that of investments like index funds, which Morningstar says had an average asset-weighted expense ratio of 0.13% in 2019.

2. One size does not fit all: Target-date funds simplify investing to such an extent that they might give investors a false sense of security or lead investors to become completely hands-off with their savings. You don’t want that.

For example, while a 2030 target-date fund theoretically suits anyone who expects to retire in 2030, not everyone who expects to retire that year has the same risk tolerance, life expectancy or projected retirement expenses.

So, you need to at least periodically evaluate your investments in light of your current situation.

As Alexander Lowry, director of the master’s program in financial analysis at Gordon College in Wenham, Massachusetts, explained in a 2018 CNBC report:

“People need to be conscious and engaged with their investment. Outsourcing that responsibility to a target-date fund is a recipe for disaster, at least in the current investing climate.”

That’s arguably still true today — especially considering the economic uncertainty that has accompanied the coronavirus pandemic.

For example, Morningstar found that the average 2020 target-date fund lost 10% in the first quarter of 2020.

That means that retirees-to-be who had invested their entire retirement savings in such a fund lost a big chunk of their nest egg as they were heading into retirement — not a position anyone wants to be in.