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Target-Date Funds Are Popular. But Mediocre Returns and Other Risks Warrant a Closer Look.

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Target-date funds’ performance has lagged behind even a balanced 60/40 portfolio, Bank of America said in a report.

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Target-date funds are the workhorses of many Americans’ 401(k) plans, but their long-term returns have lagged behind even a balanced 60/40 portfolio and their asset allocation mix pose risks that warrant attention, Bank of America said in a client note on Friday.These funds are a cheap and easy option for retirement saving, with allocations changing as time goes by to become more conservative as a person closes in on retirement. It’s a far better option than leaving assets in a money market or not investing it at all—a reason these funds have been embraced as a default in work-based retirement plans.

As a result, assets in target-date funds have ballooned to $3.27 trillion, accounting for 42% of all 401(k). They are especially popular among younger investors, with roughly 54% of investors in their 20s holding their 401(k) assets in target-date funds, according to the latest report from the Investment Company Institute looking at 401(k) plans.

But 2040 target-date funds’ performance has been lackluster, while offering minimal protection against volatility and declines than other options. Over the last 28 years, 2040 target-date funds returned a total of 750%, underperforming the 1,494% logged by the S&P 500 and even the 866% logged by a balanced 60% stock, 40% bond allocation.

Not only that, but 2040 target-date funds lagged the index by a compounded annual average 2.4 percentage points but have done so without less volatility—13.6% compared with 14.9% for the S&P 500 since March 1994, according to BofA.

BofA analysts sees three reasons for this underperformance: These funds have overinvested in shrinking, low-growth parts of the world, with nearly a third of their holdings in foreign stocks during a period where U.S. stocks—at least in the past decade or so—have dominated the market.These funds also have outdated assumptions about bonds as hedges, which have dragged on returns at the worst possible times, the analysts write. At a time many bond investors have been shortening duration as rates rise, BofA finds that target date portfolios have a duration of about 6.5 to 7 years. Indeed, for those already in retirement and invested in 2020 funds, BofA notes that these funds are down 11% or more during this year’s bear market.

And since these funds shift allocations based on time to retirement or the date of the fund, it can leave investors vulnerable to economic cycles and developments like a rising rate environment. Their approach also tends to take longer to shift to regime changes, which the market is experiencing more of in recent years given the confluence of inflection points—in monetary policy but also structural changes related to globalization and energy transition.

Others have also raised concerns in recent months, with academics finding ways to make these defaults better. Morningstar ’s John Rekenthaler earlier in the year noted the frequent criticism that target-date funds are too meek when it comes to older investors and should have bolder asset allocation—and may not be as well-suited for older investors given the myriad personalized retirement considerations that make a one-size-fits-all approach even trickier.The industry is already tinkering with these products. For now, though, like with other default options, it’s a decent one but most investors can probably do better if they take a closer look—especially amid the major economic shifts upending assumptions about both stock and bond markets.

Write to Reshma Kapadia at reshma.kapadia@barrons.com