I spend a lot of time visiting companies and meeting with their employees to talk about their 401(k) plans. The top questions I get is, “What should I invest my 401(k) in?”
For the average rank and file employee, choosing the right investments is hard, especially if finances are not your thing. And, that’s the case for most employees—investing and finance is a byzantine world full of jargon and sometimes counter-intuitive logic. But making the right investment decisions has been getting a little easier for employees.
One of the best investment innovations of the last few decades was the creation of the target-date retirement fund. This investment fund is a “one-and-done” solution for many employees saving for retirement. Essentially it’s a complete program that allocates investments across a wide range of securities that gradually becomes more conservative as you near the target date.
You select a fund with a year that most closely corresponds to your expected retirement year. Once invested, the fund’s manager determines how much to allocate to stocks, bonds and cash. Over time, the manager changes this mix to become more conservative. This change is called a ‘glide path’, which is analogous to an airplane approaching a runway to land.
Target-date funds have become wildly popular over the last few years, now garnering a substantial majority of all new cash flows into corporate retirement plans. With so much money invested in target-date funds, are they the best option for your 401(k) or 403(b)?
Pros and cons of target-date funds
This investment approach has greatly simplified the investment process for retirement. You can now select one fund and almost forget about it until you arrive at retirement.
Having conducted many 401(k) employee education meetings, target-date funds have been extremely helpful to rank and file employees. For many, their 401(k) is their biggest investment outside of their home. Many find picking their investments to be a little confusing and worrisome. Target-date funds have helped to simplify the investment selection process and get employees focused on saving for retirement—a far a more important topic.
But are target-date funds the best solution for everyone?
No. Target-date funds are designed to be an approximate investment program that is designed to meet the needs of the masses. They are not individualized investment plans. In addition, there is significant variation in how each manager allocates assets. For example, within the same target-date, the top funds have substantially different asset allocations:
Allocations of the top 3 target-date 2040 funds by assets*
As such, target-date funds do not provide an individualized investment approach. For example, if an investor has a chronic health condition with a correspondingly shorter expected lifespan, a fund’s target date would likely not be appropriate given a shorter investment time horizon.
While sophisticated investors may prefer to skip target-date funds and pick their own individual investments, the odds are stacked against them—the majority of individual investors tend to underperform market benchmarks over time. The primary reason for underperformance is trading more often than needed and not staying with a specific investment strategy for the long term.
Target-date funds can also be a good choice when your employer 401(k) plan does not have an adequate list of individual, high quality investments or, there are too few funds to adequately build out a customized investment plan. And, sometimes there can be too many investment options.
Overall, target-date funds have been a great solution for a lot of people, especially those who would like to simplify the set up and management of their retirement plan at work. Combined with auto-enrollment and auto-escalation of contributions, target-date funds have helped Americans put away more money to ensure a comfortable retirement.
More questions about target-date funds? Give us a call. We’re here to help.
Lyman H. Jackson
* Source: Morningstar, based on report created on 2/24/2020.
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.