The Pros and Cons of Target-Date Funds

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The Pros and Cons of Target-Date Funds

Man pointing at stock chart
Designed to take the complexity out of building a portfolio that changes with time, investor interest in target-date funds (TDFs) has surged. A full 64% of plan participants hold a position in such a fund and according to 401(k) researcher BrightScope, more than $1.1 trillion worth of investor money now sits in TDFs. That’s nearly a 280% increase in just five years.
With more and more plans offering target-date funds—thanks to the Pension Protection Act of 2006—and more investors looking for simplicity, BrightScope predicts that $2 trillion will be invested in these funds by 2020.

But investors may not want to jump for joy just yet. Despite having many pros, target-date funds do have several cons that need to be considered before pulling the trigger. And these pros vs. cons could ultimately push you into several funds rather than using a target date-based one. Here is our break down of these items.

Pros

Great Starting Point:

With most companies doing away with pensions, the burden of saving for retirement is falling on individuals. The problem is that most people have no idea how to put together a properly allocated portfolio. Target-date funds offer a great starting point for unfamiliar or financially un-savvy investors. By design, they offer a “one-size fits all” portfolio for a certain date out into the future. Even the most unsophisticated investor should know approximately when they’ll start their golden years.

Good Diversification:

By design, a target-date fund will invest in other mutual funds. This gives investors instant access to a variety of asset classes and market caps. For the most part, almost all target-date funds hold stocks (small-, mid-, and large-cap, domestic and international), bonds (treasuries, corporates and junk) as well as some alternatives such as real estate investment trusts (REITs). This gives a portfolio a full range of investments under one ticker.

Low Minimum Investments:

If someone were to build a portfolio of all the underlying mutual funds in a target-date vehicle on their own, the minimum initial investment could be in the tens of thousands of dollars. With target-date funds, that minimum can drop as low as $100 and investors still get access to all the asset classes.

Low Fees:

One of the problems with many early target-date funds is that they came layered with fees. Investors had to pay a management fee on top of all the fees of the underlying mutual funds. Today, many sponsors use a “roll-up” fee structure in which there is only one fee. And with assets blooming, many sponsors have shifted portfolio holdings into larger, and cheaper, institutional share classes. Today, fees on a target-date fund only cost around 0.70% annually.

Cons

Stuck with One Provider:

When you choose a target-date fund from company X, all you are going to see is company X’s funds as its holdings. While that may not be so bad at first blush, it doesn’t let investors pick and choose the best managers for each individual asset class. Investors could be leaving returns on the table. Using only one provider can also lead to a similar investment style across the underlying mutual funds. For example, American Century is historically a “growth” shop. Many of its funds have that focus.

Not as Much Diversification as You Think:

Sure TDFs all have stocks and bonds, but what about exposure to commodities, liquid-alts, infrastructure, precious metals, and master limited partnerships? Odds are, not so much. With correlations between stocks of all stripes, and even bonds, rising, these alternatives could be the key to getting through many market cycles. Some providers do give exposure, but not all. Investors may still need to add these assets to achieve full diversification.

Risk Tolerance & Age:

Target-date funds make one bold assumption: the younger you are the more risk you’re willing to take. But that’s not necessarily true. Today’s millennials have been bookended by two of the worst recessions in U.S. history. Many are afraid of stocks and prefer to save more and dial down their risk. Target-date funds don’t allow that to happen.

The Bottom Line

At the end of the day, target-date funds still make a great choice for investors looking to save for retirement. Their diversification and ease of use are a testament to their success in garnering assets. However, there are some negatives that investors need to consider. The above list highlights just some of the major pros and cons of the fund type.

Disclosure: None


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Man pointing at stock chart

The Pros and Cons of Target-Date Funds

Designed to take the complexity out of building a portfolio that changes with time, investor interest in target-date funds (TDFs) has surged. A full 64% of plan participants hold a position in such a fund and according to 401(k) researcher BrightScope, more than $1.1 trillion worth of investor money now sits in TDFs. That’s nearly a 280% increase in just five years.
With more and more plans offering target-date funds—thanks to the Pension Protection Act of 2006—and more investors looking for simplicity, BrightScope predicts that $2 trillion will be invested in these funds by 2020.

But investors may not want to jump for joy just yet. Despite having many pros, target-date funds do have several cons that need to be considered before pulling the trigger. And these pros vs. cons could ultimately push you into several funds rather than using a target date-based one. Here is our break down of these items.

Pros

Great Starting Point:

With most companies doing away with pensions, the burden of saving for retirement is falling on individuals. The problem is that most people have no idea how to put together a properly allocated portfolio. Target-date funds offer a great starting point for unfamiliar or financially un-savvy investors. By design, they offer a “one-size fits all” portfolio for a certain date out into the future. Even the most unsophisticated investor should know approximately when they’ll start their golden years.

Good Diversification:

By design, a target-date fund will invest in other mutual funds. This gives investors instant access to a variety of asset classes and market caps. For the most part, almost all target-date funds hold stocks (small-, mid-, and large-cap, domestic and international), bonds (treasuries, corporates and junk) as well as some alternatives such as real estate investment trusts (REITs). This gives a portfolio a full range of investments under one ticker.

Low Minimum Investments:

If someone were to build a portfolio of all the underlying mutual funds in a target-date vehicle on their own, the minimum initial investment could be in the tens of thousands of dollars. With target-date funds, that minimum can drop as low as $100 and investors still get access to all the asset classes.

Low Fees:

One of the problems with many early target-date funds is that they came layered with fees. Investors had to pay a management fee on top of all the fees of the underlying mutual funds. Today, many sponsors use a “roll-up” fee structure in which there is only one fee. And with assets blooming, many sponsors have shifted portfolio holdings into larger, and cheaper, institutional share classes. Today, fees on a target-date fund only cost around 0.70% annually.

Cons

Stuck with One Provider:

When you choose a target-date fund from company X, all you are going to see is company X’s funds as its holdings. While that may not be so bad at first blush, it doesn’t let investors pick and choose the best managers for each individual asset class. Investors could be leaving returns on the table. Using only one provider can also lead to a similar investment style across the underlying mutual funds. For example, American Century is historically a “growth” shop. Many of its funds have that focus.

Not as Much Diversification as You Think:

Sure TDFs all have stocks and bonds, but what about exposure to commodities, liquid-alts, infrastructure, precious metals, and master limited partnerships? Odds are, not so much. With correlations between stocks of all stripes, and even bonds, rising, these alternatives could be the key to getting through many market cycles. Some providers do give exposure, but not all. Investors may still need to add these assets to achieve full diversification.

Risk Tolerance & Age:

Target-date funds make one bold assumption: the younger you are the more risk you’re willing to take. But that’s not necessarily true. Today’s millennials have been bookended by two of the worst recessions in U.S. history. Many are afraid of stocks and prefer to save more and dial down their risk. Target-date funds don’t allow that to happen.

The Bottom Line

At the end of the day, target-date funds still make a great choice for investors looking to save for retirement. Their diversification and ease of use are a testament to their success in garnering assets. However, there are some negatives that investors need to consider. The above list highlights just some of the major pros and cons of the fund type.

Disclosure: None


Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next