What are target-date funds and why might you avoid them? Advisor Joey Acquanita explains the four reasons why you shouldn’t invest in target-date funds.
By Joey Acquanita
Aside from three letters, there is very little fun in Target Date Funds. TDF’s have become a focal point of many employer-sponsored retirement accounts. But, do they make sense for you and your situation? There are so many different options when it comes to investing in your 401k, so why settle with a fund that is made up of other funds?
I know that the last sentence is a little confusing, so let’s clear that up. Target-date funds are a “fund of funds”. This means that instead of holding stocks like other mutual funds, the fund itself holds other mutual funds. A mutual fund is simply a basket of investments such as stocks or bonds. Have you ever seen the movie “Inception” with Leonardo DiCaprio and Joseph Gordon-Levitt? It’s a similar idea here, just like there was a dream within a dream, these are funds within a fund.
Target-date funds can be traced back to the 1990s but have become much more popular in the early 2000s. The Pension Protection Act, which was passed in 2006, strengthened retirement benefits for more Americans. For example, it raised contribution limits for retirement accounts, allowed for direct conversions to Roth IRAs from qualified plans, and much more. This bill also allowed for investment advice for workplace retirement through a plan sponsor. This aspect of the bill created an opportunity for target-date funds in all Americans’ retirement accounts.
In 2017, when considering all target-date funds offered, in total, they held over $1 trillion in assets under management. Investors, who like to “set it and forget it,” have grown a strong liking to target-date funds due to the managers’ passive approach to investing. Essentially, target-date funds will assess how far away you are from retirement and create a portfolio that best recognizes how much someone should be risking at a given age. For example, someone with a longer trajectory for retirement would have more money allocated towards stocks rather than bonds and vice versa.
Why Do I Hate Them?
Hate is a strong word. I guess you could say I strongly dislike them. Most 401(k) providers offer a variety of mutual funds to diversify an individual’s portfolio. Oftentimes, there are multiple options for large-cap, mid-cap, small-cap, fixed-income, and international funds. There are many ways to be diversified without investing in a target-date fund (TDF). Here are four reasons why you should not let your friends keep their investments in a TDF.
1. Generalization of Risk Tolerance
One of the first concepts that frustrate me about these funds is that they assume all individuals have the same risk tolerance based on their time until retirement. Every individual has such a unique financial circumstance that tends to adjust their level of risk tolerance. For example, an individual may have a more aggressive risk tolerance and wants to achieve a higher level of return. An individual might be 60 years old, but he or she may still want to be invested in a portfolio with a higher percentage of equities. Risk tolerance and how they relate to an individual’s goals is one of the most important aspects of a financial plan, and target-date funds do not take it into consideration.
2. Associated Costs
Although the fees associated with target-date funds have come down in recent years, they tend to still be more expensive than compiling your mutual funds within your 401(k) provider. To start, these TDFs typically charge above-average expense fees. Big-name custodians such as Fidelity and Vanguard have index funds with expense ratios as low as 0.04% whereas TDFs average an expense ratio of 0.51%. That is a pretty substantial amount for a fund that is passive in nature. You should also be wary of being charged twice in a TDF. Since these funds are made up of other funds that also have separate expense ratios, you will need to look into these funds and make sure they do not double-dip.
3. High International Exposure
International investments come with an added layer of risk. All countries have regulatory risk, but with the latest crackdown that we have seen in China, international investments can add a level of risk that some investors are not comfortable with. For example, some target-date funds with longer time frames are over 30% international funds. Although diversification is imperative to every individual’s portfolio, it is important to look through each fund to verify what the holdings are made up of.
4. Wrong Asset Allocation
If you are planning to retire in 2050, you are thrown into a fund with assumptions of how your assets should be allocated. This fund does not take into consideration which assets you hold in non-401k accounts. Or, what if you plan on retiring at 55 years old? The asset allocation for this individual’s target date fund would not take this into consideration.
Overall, although I did bash on these funds for the majority of this article, there are some benefits. However, from my standpoint as a fiduciary, it would be unethical for me to advise anyone to invest in funds that automatically allocate assets without regard to an individual’s financial situation. That is exactly what these target-date funds do. With a little bit of research, or by contacting a professional, you should be able to diversify your retirement portfolio with other funds provided in a 401(k).
About the author: Joey Acquanita
Joey Acquanita is a financial advisor at Family Legacy Financial Solutions, a fee-only financial advising firm based out of Cary, NC. When he’s not writing for Retirement Daily, he enjoys playing and watching sports and spending time with his family.
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