The Pros and Cons of Target-Date Funds

In a recent article from Advisor Perspectives magazine, Wade Pfau, a professor of retirement income in the Ph.D program at American College,  tackles the pros and cons of target-date funds for investors.   Target-date funds (TDFs) are meant to serve as a default investment option for investors who are unable or unwilling to manage the investment options themselves.  In contrast to TDFs, advisors have the opportunity to work in the best interest of their client to obtain the best retirement outcomes through asset allocation.  Before we come to an early conclusion, lets first highlight some pros and cons of investing in TDFs:

TDFs primary objective is to begin with a more aggressive asset allocation in the early years of a career and slowly move towards a more conservative approach as the target-date of retirement nears.  Early in a career, an individual investor typically has smaller long-term savings but high capacity for earning over their career.   TDFs will typically be invested in 100% equities early in an individuals career because young workers have a long time horizon and high potential for future earnings.  As retirement approaches, that earning potential begins to shrink and the accumulation of wealth is steadily increasing which leads to a more conservative approach for TDFs.   TDFs are meant to effectively manage the preservation of an individuals assets as they close in on the target date.

A second pro of TDFs is that investors can easily invest in these funds without having to develop their own asset allocation of separate funds.  TDFs provide some level of diversification while adjusting to the individuals time horizon.  Investors who are either unable or unwilling to put forth an effort to try to outgain the TDFs performance will find that TDFs provide a simple solution.

The Cons of Target-Date Funds

One theory that hurts TDFs raised by Pfau is what is called the portfolio size effect.  Experts argue that most of the portfolio growth for individuals occurs later in their careers when they have larger balances in their portfolios.  By moving more towards preservation of those assets, TDFs miss out on growth potential of larger portfolios.  He uses the example that a 10% gain means a lot more for a $1 million portfolio than for a $10,000 portfolio.

A second argument is that TDFs may not accurately reflect the asset allocation that an individual client needs at certain points in their career because it is not customized to the individual client.  Pfau states, In 2013, Morningstar reported equity allocations for 2015 TDFs ranged from 8% to 58%.  During the financial crisis in 2008, one 2010 TDF lost more than 40% of its value.  Policy makers found this disheartening, considering widespread public perception that TDFs would guide individuals smoothly to their retirement goals.

One final criticism raised by TDFs is that it is important to check the holdings and fees closely.  Some TDFs carry high fees and may serve as a breeding ground for underperforming funds from the fund families offerings.  Many investors in TDFs lack the knowledge or understanding of these fees and funds which can affect long term growth.

No investment vehicle is perfect.  No investment opportunity is without flaw or without risk.  TDFs are no exception but can serve investors who are unable or unwilling to pursue more tailored portfolio options.  It is our job as advisors to best serve our clients and educate them on the value of proper asset allocation with or without TDFs.