Target-date funds are a common choice for employees in their 401(k) and other retirement accounts. The set-it-and-forget-it approach makes for simple investing decisions and removes the need for any portfolio management. It's all done for you.
While they're a very common choice among retirement savers, they might not always be the best choice. What's more, retirees need to take a hands-on approach to their portfolio if they want to make the most of their nest egg.
What to look for in a good target-date fund
A good target-date fund will be composed of simple exchange-traded funds (ETFs) or index mutual funds with low expense ratios. There won't be any high-fee actively managed mutual funds in the portfolio. On top of that, the target date fund won't charge much, if anything, in the way of management fees. After all, a computer algorithm could manage the fund. (That's the whole basis of the robo-advisor industry.)
Basically, it comes down to keeping the fees low.
The expense ratios on target-date funds have come down in recent years. The average expense ratio for a target-date fund was just 0.34% at the end of 2021.
Unfortunately, many 401(k) plans do not offer a low-fee target-date fund family. If that's the case, it may be worthwhile to do a little extra work and invest in any low-fee individual funds that might be available, manually rebalancing yourself if need be.
Are you all in on target-date funds?
It's important to note that an investor needs to be all in on target-date funds in order for them to really work as advertised. If you invest in some extra stocks or sector ETFs on the side, you're changing the balance of your portfolio.
At that point, you might as well invest entirely in individual ETFs that give you more flexibility and control rather than sticking to the restrictions and potentially higher fees of target-date funds.
So, if you've decided to be a target-date fund investor, you should be a target-date fund investor across all of your accounts. That's when they work best. It makes your investment choices extremely simple and it means you never have to fuss with your account, rebalance any assets, or think about selling until you've reached retirement.
Target-date funds will hold back your retirement withdrawals
If you can find a target-date fund with a low expense ratio and consistently invest money in it month after month, it'll do a pretty good job of getting you to retirement. Once you've reached retirement, though, most target-date funds don't do as good of a job at conserving your assets.
A recent study found that target-date funds aren't a great option for those who are already in retirement. "Target-date funds do not support higher withdrawal rates, considerably limit upside wealth accumulation, and fail to enhance downside protection," researchers from University of Arizona and University of Missouri wrote. In other words, you won't be able to safely withdraw as much from your portfolio during retirement, and you'll leave less for your heirs.
The conclusion makes sense. Target-date funds become extremely conservative in retirement. The example fund the researchers use increases its bond and T-bill allocation from about 65% at retirement to a terminal allocation of 83% 15 years into retirement. With the vast majority of the portfolio allocated toward bonds, the investor won't see much in the way of capital appreciation.
A better retirement portfolio is the classic 60/40 portfolio, which allocates 60% to stocks and 40% to bonds. The investor must regularly rebalance, but they can withdraw more from their portfolio while generating more wealth over time.
Target-date funds can be a helpful tool to reach retirement without having to make any investment decisions. If they help you invest and stay invested throughout your career, they can be a great tool. But investors, particularly retirees, should explore all their options to ensure a target-date fund is right for them.