Target-date retirement funds were originally created by Barclays in 1993 as a way to make it easier for regular investors to get access to a high-quality, highly diversified investment portfolio.
These days they are widely available in 401(k)s and other employer plans, as well as IRAs and regular investment accounts.
They’ve greatly simplified investing in many ways, but are they always the right choice?
This is an especially important question given that they’re often the default investment option in company retirement plans, meaning that unless you specifically choose to do something else there’s a good chance you will automatically be invested in a target date retirement fund.
In this post you’ll learn how these funds work, and the biggest pros and cons of using them, so you can make the right choice for your specific needs.
What Are Target-Date Retirement Funds?
Target-date retirement funds are a kind of all-in-one mutual fund. Each one is a single fund that is composed of multiple other funds.
Let’s look at Vanguard’s Target Retirement Fund 2050 as an example. Here’s the current breakdown of the other funds it invests in:
- 54% in a Total US Stock Market fund
- 36% in a Total International Stock Market fund
- 7% in Total US Bond Market fund
- 3% in Total International Bond Market fund
At a basic level this is incredibly helpful because instead of having to choose your own set of mutual funds, set up contributions to each, and manage them as they rise and fall in value, you get access to essentially the entire world of investments with just a single fund.
Not only that, but target date retirement funds automatically get more conservative as you get closer to retirement, and even once you’re in retirement. You don’t have to do anything, and your investments automatically adjust as you age.
But are they always a good idea? Let’s take a look at the pros and cons of using a target-date fund for your retirement.
Pros of Target Date Retirement Funds
Target date retirement funds take a lot of the difficult and confusing investment decisions off your plate and allow you to focus on the thing that matters most: making contributions.
Rather than having to analyze the entire lineup of mutual funds, ETFs, and other investments available to you, decide on the subset in which you want to invest, and then set it all up and manage it over time, you get to pick a single mutual fund that does it for you.
As investment great Peter Lynch once said, “The simpler it is, the better I like it.” Target-date retirement funds make things as simple as possible.
Of course, simplicity means nothing if the underlying investments aren’t any good. Who wants a simple and ineffective investment strategy?
Not all target date retirement funds are good (more on that below), but one thing they pretty much all offer is diversification.
Diversification is simply the process of spreading your money out over many different investments. And it’s often referred to as the one free lunch in investing because it’s the only way to decrease your investment risk without decreasing your expected return.
Looking at the Vanguard example above, you can see this in action. With a single fund, you get access to both U.S. and international stock markets and U.S. and international bond markets.
That’s about as diversified as you can get.
Target-date retirement funds automatically rebalance on a regular basis, so you don’t become over-invested in one area and under-invested in another as market values change over time.
They also automatically get more conservative over time, ensuring that your investment risk decreases as you near retirement (though, as with all investments, the risk never fully disappears).
That automation means that good things are happening to your portfolio without you even having to think about it.
Many target date retirement funds offer all of these features at a supremely low cost. And since cost is the single best predictor of future returns, that’s a very good thing.
Cons of Target-Date Retirement Funds
Of course, it’s not all roses and sunshine when it comes to target-date retirement funds, so now let’s look at some of the potential downsides.
As with all good things in the financial industry, once something catches on, there are always other companies who jump on the trend with the main goal of making a profit.
While most target-date retirement funds are fairly cheap, there are plenty of high-cost target date funds out there, too — so you have to be careful. You can review this article to see which specific costs to watch out for.
Just remember, the more you pay, the less likely you are to see positive returns.
Impersonal Asset Allocation
All target-date retirement funds have a year in their name that is meant to correspond to your estimated year of retirement.
For example, I’m 31. Assuming I retire at 67, that will be the year 2052. Which means that I “should” probably pick something like Vanguard’s 2050 fund mentioned above.
The problem with that assumption is that it takes nothing about my personal goals, needs, values, or circumstances into account. Depending on my personal situation, that 2050 target-date retirement fund may be more aggressive or more conservative than my investments should be.
You could see this problem in action during the 2008 market crash, when target-date retirement funds got a bad rap because many people didn’t understand how aggressively they were invested and lost a lot more money than they were expecting.
Asset allocation is a decision that should take many factors into account, including but not limited to your expected retirement date. For that reason, I encourage people to FIRST decide on their asset allocation, THEN pick a target-date retirement fund that closely matches it, even if the year in the fund’s name doesn’t match when you expect to retire.
While target-date retirement funds automate a lot of the good behaviors any investor should be implementing anyways, there is still no performance guarantee.
Just as with any investment, there will be big swings in every direction. And there will certainly be days, months, and even years where your target-date fund produces a negative return.
This isn’t really a downside of target-date funds as much as it’s a reality of investing in the stock market. It’s just important to understand that these funds are no different.
Lack of Control
You can’t implement your specific investment preferences with a target-date retirement fund, unless you find one that closely matches what you would have done anyways.
For most people this really shouldn’t be a problem, since the truth is that none of us are particularly good at forecasting which specific investments will outperform over any given period. So the odds of your particular strategy outperforming a good target-date retirement fund are a coin flip at best.
But if you have a specific plan you want to implement, such as a socially responsible investing strategy, you’ll probably have to look elsewhere to do it.
If your investing extends into taxable accounts, there are certain strategies you can implement to minimize the tax hit on your investments.
Because target-date retirement funds are all-in-one, they make it difficult or impossible to implement these strategies. That doesn’t necessarily mean that you’ll end up with a big tax bill, it just means that they likely won’t be optimal.
Keep in mind that for the majority of investors, most of whom save for retirement in a tax-advantaged account such as an IRA or 401(k), this will be a small to non-existent downside.
If you have access to a low-cost target-date retirement fund and both understand and like the investment strategy, it should probably be your default option.
It’s not that you’re guaranteed to outperform all other options that way (you’re not). It’s that it’s impossible to know ahead of time which strategy will outperform and a good target date retirement fund will have as good a strategy as any.
Add that to the fact that they’re incredibly easy to both set up and maintain and they’re a fantastic option.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.