The Difference Between Professional Help and a Target Date Fund
Some mutual fund companies market Target Date Funds (TDFs) as the one-stop-shop for your investments. While TDFs may have their place in your investment portfolio, they by no means replace the need for the holistic approach offered by qualified financial advisors.
As TDFs grow in popularity, we at Scarborough Capital Management are asked about them more regularly. So, in this article, we’ll explain how TDFs work and explore their pros and cons. Then we’ll see how professional advice differs from these funds, and how the two can work together to help maximize your retirement opportunities.
What Are Target Date Funds?
Target Date Funds are funds-of-funds that are set up to slowly change your investment allocation as you approach a specific date/year. They do this by updating the investment allocation from a high mix of assets like stocks and lower-quality bonds to a higher mix of investments like high-quality fixed income instruments and cash. This corresponds to the adage that you should reduce risk in your portfolio as you age, because you have fewer years to recover losses from more volatile investments.
Asset allocation is an important aspect of managing risk. When you are relatively young, the fund may have 80 percent or more invested in the stock market and may use index funds. An index fund mimics the returns of a benchmark index, such as the S&P 500 Stock Index. As you approach the target date, the fund’s asset allocation may shift to a bond index, such as the S&P Treasury Bond Index. The target date fund may have you out, or nearly out, of stock investments at and beyond the target date.
On the face of it, this strategy helps you take advantage of the value of compounding. By keeping your money working in various index funds, you can reap the long-term rewards of compounded earnings. You pick the fund with the appropriate target date, which can be your anticipated retirement date or some other milestone. Once you pick the fund, you let it take care of all investment decisions – it’s investing on autopilot. All you need do is make contributions according to your ability.
Popularity of Target Date Funds
Make no mistake, the popularity of TDFs is on the rise. From 2015 to 2022, TDF assets rose from $1.3 trillion to $3.27 trillion. In 2021 alone, investors poured $170 billion into target-date strategies, up more than three-fold from $52 billion in 2020 according to Morningstar's "2022 Target-Date Strategy Landscape" report.
A report by The Employee Benefit Research Institute (EBRI) and Investment Company Institute (ICI) found more 401(k) plan participants are using the funds than in the past. EBRI and ICI examined year-end 2018 data from the EBRI/ICI 401(k) database—which follows millions of 401(k) plan participants to examine how these participants manage their plan accounts—and found that 56% of participants in the database held target-date (or lifecycle) funds. That’s up almost 200% in 12 years. TDFs also held 27% of total 401(k) plan assets in the database.
There are several reasons for the popularity of TDFs:
- It is often the default investment choice for employee 401(k) plans.
- The set-it and forget-it aspect of TDFs appeals to many investors.
- Mutual fund companies heavily market their TDFs.
The Draw of Target Date Funds
The advantages of TDFs include:
- Simplicity: These funds need no management from investors because the investment manager makes all decisions regarding asset allocation. It’s a hands-off approach to investing in which investors trust fund managers to make the right choices over time.
- Diversification: TDFs are diversified over stocks, bonds and cash. Some may also include alternative investments such as real estate or commodities. The fund-of-funds arrangement used by TDFs facilitate asset diversification across several markets.
- Age appropriate: By shifting assets over time TDFs help you achieve a risk profile that may be more appropriate for your age, on average.
Disadvantages of Target Date Funds
TDFs also have their disadvantages, including:
- Expenses: TDFs tend to be expensive compared to index funds. The difference really builds up over the decades in which you keep your money in the fund.
- Taxes: Taxes can be a problem if you hold a TDF outside a tax-sheltered account such as an IRA or 401(k). Whenever the fund reallocates assets, it creates taxable events in which you have to pay taxes on any capital gains you earned from the sold investments.
- Variability: Different TDFs have different reallocation strategies. Thus, different TDFs for the same target year may have different asset allocations. The TDF you choose may not deal with risk in a way that matches your own preferences, putting you into asset allocations that are too aggressive or conservative for your individual tastes. This makes it important for you to research different TDFs before making a commitment. Talking with a financial advisor can be a huge benefit.
The Role of a Financial Advisor
A TDF can do a reasonably good job of controlling your asset allocations to match, on average, the recommended allocations for a person of your age. The problem is, you might not be average.
A financial advisor’s task is to assess your individual needs and offer custom solutions. A financial advisor can also reshape your financial plans as warranted by changes in your life, such as a change to your projected retirement date.
In fact, a financial advisor can provide a holistic approach that goes beyond retirement planning. An advisor can help you plan your tax strategies, insurance coverage, investment portfolio, charitable contributions and estate plans among other things. There are a number of concerns that a professional can address that a TDF doesn’t.
That’s not to say that a financial advisor won’t include a TDF in your investment plan. But the advisor can search for the fund that makes more sense for your circumstances. TDFs can vary greatly, and it’s up to your advisor to help you select the one that best meets your needs and review important items like cost. A financial advisor may have you place a portion of your retirement money into a TDF, but also have you allocate money to other types of investments.
Finally, financial advisors can answer your questions. A financial advisor can take the time to understand your financial goals and respond quickly if those goals change. If you prefer a human touch, a qualified professional is your best choice when navigating your financial future.
Target Date Funds offer the virtues of simplicity and convenience, at the cost of impersonal decisions that could mean higher taxes and expenses. Working with a financial advisor can provide the custom, well-rounded advice you may need for your unique financial circumstances and goals. The two aren’t mutually exclusive, and the best solution may be to use an advisor who employs TDFs as one tool within the financial toolbox.