While there’s no such thing as a perfect retirement investment, some experts might argue that target funds come close. These funds take the guesswork out of rebalancing by automatically adjusting asset allocation based on a timeline specified by the investor.
“Target-date funds have become popular because they offer an all in one solution,” says Denny Baish, a senior investment analyst and portfolio manager at Fort Pitt Capital Group in Pittsburgh.
Target-retirement funds can offer streamlined diversification and often appeal to those who are comfortable with a hands-off approach. Baish says these funds are common in retirement plans for participants who don’t want to bother, don’t have the time or simply don’t know how to build out a proper allocation.
But these types of funds are not without certain flaws. For some investors, a retirement strategy that’s free of target-date funds could make more sense. Here are four reasons to rethink adding funds with a target date to a portfolio as part of your investment strategy:
- Control is limited.
- There’s little room for personalization.
- Underinvestment is a hidden risk.
- The costs can be deceptive.
You Have Limited Control
Target-date funds leave very little for an investor to do in managing their portfolio, which may not be a good thing.
Baish says these funds take control of asset allocation, fund manager selection and strategic decision-making out of investors’ hands. “Basically, the investor can’t make any changes,” he says. “That decision is now up to the target-date fund’s managers and fund company.”
That can be a problem if the underlying investments within the fund are of unequal quality. While there may be some winners in the bunch, there could also be a mix of mediocre or under-performing investments that detract from performance. There’s not much an investor can do about it, however, other than selling the fund altogether.
Baish says researching individual funds and building a customized asset allocation is the best option. This way, the investor retains control when it comes to the quality of funds included, the weighting of stocks, bonds and cash and the frequency of rebalancing.
There Is Little Room for Personalization
Employer-sponsored retirement plans may use target-date funds as the default investment option, but these funds shouldn’t be accepted at face value. Michael Finke, professor of wealth management at The American College of Financial Services, offers an analogy for understanding how target-date funds compare with other investments.
“Think of them as a generic commodity like white flour,” Finke says. “White flour is fine for most people, but many would like whole wheat or almond flour more and some are gluten-intolerant. A target-date fund gives all workers with the same retirement date the same asset allocation, even though some obviously will be more risk tolerant than others.”
For instance, if a pension plan is offered alongside a 401(k) or similar workplace plan, Finke argues that those workers may be able to take more risk with their investments. At the same time, he says plan sponsors may favor riskier target funds. Workers who are placed in these plans by default may not understand how much risk they’re taking or how that aligns with their risk tolerance.
Finke says investors who are comfortable choosing investments and want a more customized approach should consider index funds. Tax-inefficient investments, such as bonds or a real estate investment trust, known as REITs, can be added to tax-advantaged accounts while exchange-traded funds, or ETFs, may have to be placed in a taxable brokerage account. “This will provide a higher overall after-tax return rather than simply investing in balanced funds in both types of accounts,” Finke says.
There Are Hidden Risks
It’s a misconception to think of target funds as the safest retirement investments; even the best target-date funds are not completely risk-free. One of the biggest risks to be mindful of is underinvestment, says Troy Dryer, vice president of business development at IPX, a company owned by FPS Group.
That risk stems from the fact that target-date funds don’t all follow the same rules for establishing asset allocation. Some funds use retirement age as a guide in determining a withdrawal date while others project life expectancy. It a subtle difference but one that can’t be overlooked.
“If your target-date funds only invest to retirement and not through retirement, you may be underinvested,” Dryer says. Longer life expectancy means a longer window in which a portfolio must be able to sustain an investor’s income needs.
Dryer says actively managed mutual funds and ETFs should be considered for balancing risk and diversification when looking at retirement funds. Money managers are equipped to manage assets in a changing market while target-date funds lack the capacity to react to economic or political changes.
The Costs Are Deceptive
Some people may lean toward target-date funds based on the assumption that these funds are a cost-efficient way to invest. But that can be misleading.
“It’s very difficult to really understand what the costs are within a target-date fund,” says Guy Baker, founder of Wealth Teams Alliance in Irvine, California.
This is because target funds may include several asset classes and the published cost is a composite of those internal fund expenses, Baker says.
The average investor may not be able to easily evaluate the turnover or the asset class expenses following that structure. Baker says managed accounts can offer more transparency because there’s typically a stated cost to the investor.
Whether it makes sense to stick with target-date funds or not ultimately depends on someones personal preference. Experts acknowledge that they can be a good fit for some investors such as when someone is new to investing and only has a smaller amount of money to start their investment portfolio.
Understanding the fund’s composition, how often rebalancing occurs, risk exposure and fees are critical to making an informed decision about to use them for retirement.
“While target-date funds might be easier, it doesn’t necessarily mean they are a fit for every investor and their retirement plan,” Baish says. “Education is key, so be sure to ask your advisor any questions you might have.”
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