Target-Date Funds (TDFs) were introduced in the early 1990s and they have grown in popularity ever since. In recent years, their appeal has surged even more, driven partly by the auto-enrollment legislation of the Pension Protection Act of 2006. This legislation necessitated the establishment of safe-harbor type Qualifying Default Investment Alternatives, leading to the widespread adoption of target-date funds in 401(k) savings plans.
The Concept Behind TDFs
TDFs operate on the principle of simple investment. There’s no need to worry about the ratio of stocks to bonds or the types of stock in your portfolio. The investment strategy is also dependent on your age. Investors choose a target-date fund based on their intended retirement year.
Your target-date fund’s investment manager can adjust your investment over time. As you get closer to your desired retirement age, they may shift from riskier stocks, which are more likely to lose value in the short-term, to safer bonds and other investments. The goal of the adjustment is to help you protect your principal as you get closer to retirement.
Disadvantages of TDFs
Here are several reasons why you might want to think twice before making target-date funds your primary retirement investment choice.
As people continue to spend a larger portion of their lives in retirement, it’s clear that we need our investments to grow during this period. As inflation erodes purchasing power, it’s become common for investors to remove money from their nest egg each year to cover expenses. This reason is why it’s likely retirees will always want a substantial amount of their portfolio in equities as stocks tend to perform better over the long term.
Not-So-Active Asset Allocation
TDFs in 401(k) plans often have asset allocations that may not be flexible for the current environment. For instance, they might have a significantly higher exposure to international stocks prone to higher market volatility because of currency fluctuations, geopolitical events, and varying economic conditions in different countries.
This category has produced underperformed domestic stocks over the past couple of decades. TDFs also have a larger allocation to intermediate-term bonds, which are sensitive to changes in interest rates. Last year when interest rates rose substantially, the value of these bonds significantly declined.
They Sell When You May Not Want To
The year 2022 was tough for the stock and bond markets. Most advisors would likely not have suggested to sell stocks at the end of such a down year but that is exactly what these funds did because they followed their formula of selling as we age annually and therefore, to some extent, they missed on some of the big rebounds in 2023.
The 3 Bucket Approach as a Way Forward
We advocate for taking an all-weather approach that is designed to provide you options in up and down markets and to account for the increasing likelihood of long life in retirement.
A Volatility Buffer
Set aside extra cash or cash equivalents in your portfolio to shield yourself from market downturns. With a buffer, you can sidestep the need to sell stocks at a loss during market volatility. You’ll be able to preserve your capital and safeguard your retirement fund.
Designate an income-generating bucket in your portfolio with income-producing assets, like bonds and dividend-paying stocks. As retirement approaches, gradually allocate more of your assets to this income-generating bucket to accumulate enough to cover your living expenses in retirement. Many studies suggest that a ratio 60% stock to 40% bond in your portfolio will be the most sustainable during the distribution phase.
Allocate a specific portion of your portfolio to a bucket for long-term investments, designed to keep pace with the market since you have ample time to navigate and endure market fluctuations.
Target date funds supply a "one stop" option, which are designed to provide you with an asset allocation based upon the presumed retirement date of the investor or the date money is to be withdrawn (i.e. the target date), usually at retirement. Typically, these are a fund of funds and have two layers of fees and expenses. The principal value of a target date fund is not guaranteed at any time, including at the target date. Target date funds allocation move toward emphasizing cash and fixed income elements as the funds approach their maturity or target dates. By reducing exposure to the growth elements, the risk of a sudden drop in the market affecting the retirement date diminishes.