Target-date funds are some of the most popular choices for retirement savers in employer-sponsored retirement plans like a 401(k). They offer a simple set-it-and-forget it option for investors. Just pick the year you plan to retire, and the fund manager will take care of the rest, automatically adjusting asset allocation and rebalancing when necessary.
But there are significant drawbacks to using target-date funds as part of your retirement savings. Here are five big ones.
The only metric a fund company uses to determine how it manages its target-date funds is the target date. It doesn't account for your own individual risk tolerance. As a result, target-date funds often have too much or too little equity exposure for each individual investor. That's evidenced by the fact that it's hard to find two target-date funds with the same target date and the same asset allocation.
If you're going to take the time to dive into all of your target-date fund options to see which one is best for you and your risk tolerance, it kind of defeats the purpose of the simplicity of target-date funds. You might as well put together your own portfolio of index funds.
2. Stuck with one mutual fund company
Every target-date fund is made up of individual funds representing each asset class. If you were to invest in individual funds yourself, you might buy an ETF from one fund company and a mutual fund from another to put together your portfolio. You might shop based on expense ratios or how well a fund tracks its benchmark index.
When you buy a target-date fund, every fund within the fund comes from the same company. As a result, you may end up with some subpar funds in your portfolio.
3. No accounting for outside assets
Target-date funds work best when you invest all of your savings in them. If you're investing outside the target-date fund, the asset allocation of your whole portfolio is going to be different from what the target date targets.
Many investors will choose a target-date fund in their 401(k), but then stick with index funds or individual stock investments in their IRA and taxable brokerage account. That completely ruins the effectiveness of a target-date fund. Investors must consider their entire asset allocation across all of their investment accounts.
It's possible to invest in target-date funds outside of your 401(k), but you may not have access to the same exact funds across your accounts.
If you're saving for retirement outside of your 401(k) plan (and you should be), a target-date fund probably isn't going to be as effective as it would be otherwise.
4. The fees
Target-date funds can be quite expensive relative to index funds. The average target-date fund expense ratio was 0.52% in 2020. While that's an improvement from five years ago, when funds charged an average of 0.73%, it's still much higher than most index funds, which you can typically find for less than 0.2%.
Part of the problem is that once you pick a target-date fund, you're locked into a single fund company for each index fund held within the fund, so there's no opportunity to shop around for price on each individual fund. And because you're locked in, the fund company has less competitive pressure and can charge more.
There's also a convenience factor. Not only are you paying the expense ratios of each individual fund within the target-date fund, you're also paying for a manager to properly allocate your investments.
5. Poor asset allocation in retirement
The best target-date fund can do a good enough job during your working years, but once you get into retirement, most funds have a fundamental flaw that makes them poor investment choices. Some funds will stop changing their asset allocation once they reach the target date. At that point, the manager's job is simply to rebalance the portfolio when it deviates off target. Others will continue to allocate more money toward bonds.
While that's common financial guidance, it falls prey to the issues presented above about one-size-fits-all and how target-date funds can't account for outside assets.
The biggest factor for retirees to consider with regard to their asset allocation is their Social Security benefits, and how that impacts their asset allocations. You can treat Social Security in a very similar way as an income-producing asset like bonds, so you may become overweighted toward the fixed income asset class if you keep your target-date fund.
There are other factors to consider regarding asset allocation besides your age, and target-date funds cannot take those into account, mainly because they know nothing about your individual financial needs in retirement.
If you've read this entire article, you're the type of person who doesn't mind learning about investing. Take the time to learn to put together a portfolio that fits your needs. Manage your asset allocation across all of your investment accounts, and consider asset location as well. That will get you much further than relying on target-date funds to do the work.