Today, target-date funds (TDFs) are nearly a $1 trillion industry.
They’ve taken over as the default investment of choice in workplace retirement plans, and have become a favorite of investors looking for a simple all-in-one solution. To serve those needs, Vanguard recently launched the Target Retirement 2065 Fund, believed to have the longest time horizon in the target-date fund universe.
But target-date funds aren’t infallible, especially those that plan out five decades into the future. In this article, we’ll examine the structure of long-term target-date funds and how they might not always work for investors.
In case you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.
How Do Target-Date Funds Work?
TDFs are portfolios that design a mix of stocks, bonds and cash geared toward investors who anticipate retiring at a specific age. Those funds start out invested mostly in stocks and follow a glide path that slowly becomes more conservative as the target date approaches. TDFs can manage ‘to’ retirement, where they generally lock in the final asset allocation once the target date is reached, or ‘through’ retirement, where they continue to be allocated more conservatively after the target date.
Know why custom target-date funds can be a better option than the traditional ones here.
So why might longer-term TDFs not necessarily work in all situations? Here are five reasons.
1. They’re Geared Toward Age Groups, Not Individuals
One of the big problems with target-date funds is that they assume everyone within a particular age group is the same. Within that group are people that want to take on greater risk and those that want to be more conservative.
It’s safe to say that really long-term TDFs will be mostly, if not entirely, invested in stocks. Consider this. The 2065 fund will be geared toward people straight out of school, many of whom probably haven’t invested before and may be uncomfortable with market risks. For individuals, TDFs may offer an asset allocation and glide path that is inconsistent with their personal preferences. Further complicating matters is the fact that each investment provider offers their own glide path.
Check out our target-date fund section to remain up to date with the trends in this space.
2. They’re Usually Not Customizable
With TDFs, you get what the fund provider offers you.
Using the example above, what do you do if you aren’t comfortable with stock market risk? If you don’t want 90-100% of your money tied up in the stock market, you’re left looking elsewhere for an appropriate option. The same problem surfaces if you want to make any tactical adjustments to your portfolio. If you feel that a particular sector of the market is undervalued and you want to try to take advantage of it, TDFs aren’t going to be able to help. They’re locked into a glide path regardless of the economic environment.
3. You’re Not Guaranteed Anything When You Retire
Investors that contribute to a TDF can control what they put in, but not what they get out. There is no defined benefit with target-date funds, which can potentially complicate long-term planning strategies. If you’re a risk-averse investor, the notion of contributing to an account for 50 years and not knowing what you’ll get out of it can be off-putting.
That may slowly be changing, though, as some fund providers along with the Department of Labor are exploring the idea of layering annuities into TDFs to provide a guaranteed fixed income component.
Be sure to check how target-date funds including annuity-like options might be a better choice.
4. Target-Date Funds Can Still Be Confusing
While target-date funds have been great at raising investor awareness and getting folks off on the right foot in preparing themselves financially, investing is still far from intuitive for most people. For all their benefits, it can still be difficult to understand how a TDF actually works.
When we consider longer dated TDFs, young investors may have trouble with the notion of contributing to a product they don’t fully understand for even a short period of time, let alone a few decades.
5. Investors Can Still React Emotionally
Over the course of 40 to 50 years, investors can expect to see several bear markets along the way. Odds are at least one of them will be severe.
TDFs are built to be all-in-one investments that should be held until the target date, but that’s not always what happens. Investors often get panicky and can be their own worst enemy when it comes to riding out the market’s highs and lows. Emotion-fueled buying and selling or attempting to time the market can severely diminish a portfolio’s returns over time. Investors unwilling to ‘set it and forget it’ may not experience the built-in portfolio management benefits that these funds offer.
The Bottom Line
While target-date funds have been one of the most investor-friendly creations in years, they do have some potential drawbacks. TDFs with target dates far out into the future will have heavy allocations to stocks, but investors need to be aware of the risks involved before jumping in. These more aggressive portfolios need to be consistent with individual risk tolerance and goals. If it’s not a match, it could really impact the size of your retirement nest egg.
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