Are Target Date Funds a Good Option?
401k investment fund lineups are all relatively similar, but can be very confusing for the novice investor. They have a mix of active and passive funds, bond funds, specialty funds and stable value funds (i.e. cash accounts). If an employee can’t decide, the 401k plan will invest the retirement contributions into a qualified default investment account (QDIA). A QDIA used to default to the stable value account, but a few years ago the government decided it was in the investors best interest to use Target Date Funds instead. Stable value accounts are very safe, but earn minimal interest which isn’t ideal for most retirement investors. So, are Target Date Funds a good investment option?
When Target Date Funds Make Sense:
Target Date Funds provide investors with two important aspects of a solid performing portfolio; Asset allocation and professional investment management. Asset allocation is broadly the mix of stocks vs bonds as well as different asset classes within that mix (Large US company stocks vs Small US company stocks). Contrary to popular belief, asset allocation is going to be the main driver of portfolio performance over time. Picking the right asset allocation mix can be challenging.
Target date funds help 401k participants with professional investment management. Target date funds have a professional (or team of professional) investment manager selecting the asset allocation, they rebalance the fund when necessary and they can make educated judgements future markets. Considering the average investor consistently underperforms the market, this may not be a bad option.
What are the Drawbacks?
There is no perfect investment and target date funds are no exception. Target date funds can have higher fees compared to other investment options within a 401k plan. Furthermore, there is a lack of understanding of how target date funds work.
Target date funds invest the allocations based on a glide path. Basically, a glide path tells the fund manager when to shift from risker stock investments towards bond investments. For the young investor, this doesn’t mean much. For the investor approaching retirement, this could be a big issue. There are two types of glide paths; through and to retirement. If a target date funds manages through retirement, then they assume that a retirement will last twenty years. As a result, the fund will invest with a greater allocation of stocks over bonds. To retirement target date funds that invest “to” retirement will invest more conservatively at age 65. For a person nearing retirement that can be a significant difference and it's important to understand.
Overall, target date funds are a good option if there is a need or desire for a professional to manage the 401k investment contributions. However, it’s important to understand how the fund manager is investing over time. Make sure it’s in line with your goals and your risk tolerance.