In recent years an increasing number of employers are adding so-called “target date” funds to their 401(k) menus. In many cases, they are the default option for employees when they start contributing to their accounts. These funds typically include a year in their name and are mutual funds that shift investment allocations over time in anticipation for a “target” retirement date.
Target date funds are designed around generally accepted investment theories where higher risk/ higher potential return investments like stocks should have a larger allocation in the early years of a career. As retirement nears, that allocation should shift towards investments in bonds and cash, which tend to be less volatile. In general, these funds make it much easier for employees to “set it and forget it”, but not all target date funds are created equal and some may not fit into a successful retirement plan.
Here are a couple of ways these funds can fall short.
One target date does not fit all
Depending upon each investor’s total financial picture, the target date may not match up with their overall risk profile. In some cases, the 401(k) may make up a small portion of an investor’s total net worth. In that case they may wish to be more aggressive even as retirement approaches since 401(k) money may not be used for many years. On the other hand, some investors may be relying on their 401(k) for the bulk of their retirement funds and a target date fund will not provide enough stability to stomach market swings when retirement is only months away.
There’s no such thing as a free mutual fund
As with most financial products, there is a price to pay for this packaged “solution”.
The fees in target date funds vary widely, from reasonable to exorbitant. Many 401(k) plans offer low expense index mutual fund options that may be much less expensive than those paid in a target date fund. By combining these index funds, employees may be able to create their own custom target date fund at a fraction of the price.
In a recent example with a client, Wilson Capital was able to create a portfolio of mutual funds that replicated the investment allocation of his target date fund. The result was a portfolio with a total fee of 0.25% versus 0.75% for a JP Morgan target date fund, working out to a difference of $5 per $1,000 invested in his 401(k).
If fees are the primary concern about using target date funds, the offerings from Vanguard and TIAA-CREF are more reasonably priced and worthy of an allocation if they are available in a 401(k) plan.
Despite some shortfalls, target date funds protect from a wayward 401(k) allocation. For those people without the desire or time to tinker with their 401(k), target date funds might still be the best option.
The information presented here is not specific to any individual’s personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
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