The Pros and Cons of Target Date Funds
The investment world was changed significantly and forever in 1924 with the invention of the mutual fund. For the first time, investors could pool their assets under the watchful eye of a manager and purchase a basket of investments – be them stocks, bonds or some combination. The next big change came in the early 1990s when target date funds (TDFs) were first invented. It wasn’t until 2006 with the Pension Protection Act that the market for target date funds really expanded. This act allowed for auto-enrollment of TDFs into defined contribution plans and set the stage for QDIAs (Qualified Default Investment Alternatives), which strongly supported the growth of these funds.
A TDF has the same basic construction of a mutual fund with one major difference. Over time, the asset allocation between stocks and bonds inside the TDF typically becomes more conservative, shifting asset allocations from stocks to bonds. The rate at which this shift in asset allocation is made is known as “glide path,” and can differ widely from investment company to investment company producing the TDF. This reflects a difference in philosophy as to the “ideal” asset allocation at any given age. Whether changes in the asset allocation cease at the target retirement date or continue to reallocate assets beyond that date is the difference between “to retirement” or “through retirement” TDFs.
As with most anything else in the investment world, TDFs have their pros and cons making them great for some investors, and maybe not so great for others.
Pros of TDFs
Perhaps the single greatest benefit to using TDFs is to “set it and forget it.” Theoretically, the investor can select the TDF that best aligns with their assumed retirement date and let the fund and fund manager do the rest. This may work especially well for the novice investor because it makes investing very easy – line up an assumed retirement date (or date of birth) with a particular TDF and they are done. TDFs work particularly well inside 401k plans.
There are other considerations as well, namely whether to use passive (index) or actively managed TDFs and what glide path is best to use. In 401k plans, the plan trustee or ERISA 3(38) Investment Manager will typically make those decisions.
Cons of TDFs
The primary drawback to TDFs is that no investor input, aside from age, goes into the decision of what TDF to use. Investors typically at least want to take into consideration investment risk tolerance and experience when making investment allocation decisions. Almost uniformly, TDFs are designed to be most aggressive at younger ages, and progressively get more conservative the older the investor gets.
The biggest challenge is that this may be exactly backwards to how the person would otherwise invest. Very often, younger people choose to be more conservative given their lack of experience in investing, while older people may feel more comfortable with a higher level of risk based on their experience.
For individual guidance on the use of target date funds, please contact our office.