Target-date funds (TDFs) have seen a meteoric rise in 401(k) plans, becoming a staple investment choice for many employees wishing to secure their financial futures. As reported by the Plan Sponsor Council of America, TDFs captured nearly 29% of total assets in 401(k) plans as of 2023, an impressive increase from only 16% in 2014. Projections by Cerulli Associates suggest that this trend will continue, with TDFs potentially accounting for 66% of all 401(k) contributions and 46% of total assets in the next few years. Employers have largely adopted TDFs as the default option for workers automatically enrolled in their 401(k) plans, largely due to their simplicity and the assurance they bring to employees who may lack the financial literacy needed to manage their investments effectively.
The primary appeal of TDFs is their automated approach to retirement investing. Designed to gradually adjust their asset allocation based on an investor’s anticipated retirement date, these funds can ease the burden of investment management for many individuals. For instance, a 35-year-old planning to retire in 30 years might choose a 2055 fund, which would become progressively less aggressive as the target date approaches. This hands-off model serves as an excellent option for those who prefer a straightforward investment strategy without the complexities of actively managing multiple assets. Financial professionals like Christine Benz, Director of Personal Finance and Retirement Planning at Morningstar, view TDFs as revolutionary—providing affordable and sensible investment choices for those who might otherwise make poor financial decisions.
However, the automatic nature of TDFs can create a false sense of security. Investors may lack the awareness of the risks associated with their chosen fund, particularly regarding how different asset allocations can affect their long-term outcomes. TDFs may not align with an individual’s particular financial situation, investment preferences, or risk tolerance.
While TDFs offer a convenient one-size-fits-all investment solution, they can fall short for many individuals with unique financial situations. For example, retirees with substantial savings outside their 401(k) may not be well served by the standard allocation strategy that TDFs follow. Just because two individuals plan to retire at the same age does not mean they have the same financial needs or risk tolerances. Factors such as current savings, life expectancy, and investment objectives for retirement can vastly differ, and TDFs do not account for these variations in their model.
Moreover, various TDFs from different asset managers can vary significantly in their investment approaches. A fund categorized as “aggressive” could still allocate as much as 60% of their assets in equities, despite being labeled for an imminent retirement date. This discrepancy emphasizes the need for investors to conduct thorough research on their chosen TDF, as not all funds are created equal.
Understanding the elements of risk in TDFs is crucial for making informed investment choices. As Carolyn McClanahan from Life Planning Partners points out, investors need to acknowledge that TDFs carry different risk levels depending on the fund’s specific composition and how long they expect to draw on the investments. Since many funds are heavily weighted in equities, investors with a higher aversion to risk may find themselves in over their heads.
Additionally, TDFs do not lend themselves well to “tax location” strategies. This investment technique involves placing certain asset types in particular accounts to enhance after-tax returns. For instance, high-growth assets are often better suited for Roth accounts, where earnings can grow tax-free, whereas bonds should ideally be held in tax-deferred accounts. The absence of this strategic thinking in TDFs could be a significant drawback for investors who are looking to maximize their after-tax investment growth.
Target-date funds undoubtedly offer significant advantages, particularly for novice investors unfamiliar with the investment landscape. Their ease of use and automatic rebalancing provide a framework that can guide unsophisticated investors toward a balanced portfolio as they approach retirement. However, for more experienced investors or those with particular financial goals, TDFs may represent a limited choice that doesn’t adequately reflect their unique needs.
While TDFs may serve a critical role in the portfolios of many 401(k) investors, they are not without flaws. Individuals must carefully consider their long-term objectives, risk tolerance, and financial condition before opting for such a default investment. Making informed choices about whether to embrace this trend can significantly impact the success of one’s retirement plan.