Why Target Date Funds Miss the Mark

Over the last decade, target date funds have increased in popularity among investors. Target date funds are especially prevalent within 401(k) plans, as they are often promoted to participants as a “set it and forget it” investment solution. According to the Investment Company Institute 2020 Fact Book, nearly $1.5 trillion is now invested in target date funds, the vast majority within 401(k) plans.

For those unfamiliar with target date funds, the fund automatically rebalances the asset mix for a predetermined time frame. Investors typically pick a target date that coincides with their anticipated date of retirement, with the fund reducing equity exposure the closer one gets to retirement. The appeal of target date funds is that they help simplify the complex. The portfolio rebalancing responsibility belongs to the fund manager, with no action required by the investor.

Most investors would probably expect target date funds with the same target date to have roughly the same asset mix, but our experience shows funds with the same target date can have significantly different asset allocations.

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Let’s look at four target date funds with the same target retirement date of 2025 from four large mutual fund companies (all data below is as of 12/31/20):

As you can see, the asset allocations vary significantly, even though each fund has the same stated target date.

Here are several takeaways for investors using target date funds:

• Be sure to look under the hood: Investors should explore the asset allocation of the fund. We prefer target date funds that incorporate international and emerging market equity exposure as well as U.S. equities.
• Expenses matter: Expenses are a direct reduction in return; the average target date fund’s expense ratio is 0.62%, according to ICI. Look for funds with expenses below the average.
• Don’t be too conservative: The old rule of thumb for asset allocation was subtract your age from 100 and that would be your equity allocation. But consider that for a married 65-year-old couple retiring in 2021, the probability that at least one person will live to age 95 is 50%. The rule of thumb may well be too conservative for maintaining purchasing power over a nearly 30-year retirement period.

Target date funds can be a valuable tool for investors, but remember, even funds that help simplify investing require due diligence and monitoring.