Target-date funds continue to gain in popularity for retirement funding. They offer an easy way for investors to decide once and then not have to think about allocation or rebalancing within their portfolio. But that simplicity comes at a cost.

Successful use of target-date funds requires understanding what you’re getting and how to best make use of these powerful tools.

What Is a Target-Date Fund? Some Background

Target-date funds came into being in the ’90s. They use an asset allocation approach to investing across asset classes to minimize portfolio volatility. What that means is that the portfolio manager is allocating a portion of the portfolio into each of a number of asset classes, then rebalancing across time to maintain the portfolio mix.

Asset allocation helps reduce portfolio volatility by taking advantage of different markets working in different directions at the same time. As one asset class grows out of proportion relative to others, a portion is sold and those profits are allocated to the lower-performing asset classes.

This removes our human bias and forces us to sell high and buy low.

Target-date funds take the asset allocation one step further by adjusting the asset allocation across time to become more conservative as the target date approaches. This transition from a high-growth portfolio many years prior to the target date to a conservative portfolio as the date approaches is commonly referred to as the portfolio’s glide path.

Target-date funds are the funds of choice for automatic enrollments into retirement plans. This has fueled their growth.

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Age as an Investment Factor

Age is certainly a factor in investment selection. It is often considered the primary determinant on how aggressive or conservative an investor should be. As such, a fund that adjusts across time to implement a gradual reduction in risk makes sense.

This is also a common factor in 529 college savings plan investments. Most offer age-based portfolios that begin aggressively (when the future student is young) and gradually become quite conservative by the time you need the funds.

It’s also important to note a fundamental difference between retirement and education goals. People typically need education funding for a relatively short period of a few years. But they typically need retirement funding for a far longer period. We’ll come back to this shortly.

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Advantages of Target-Date Funds for Retirement Planning

Target-date funds accomplish several objectives with little or no input required from the investor.

You really can’t beat the convenience. There’s simply no easier way to invest.

Perhaps we should qualify that as no appropriate easier way to invest. You select a fund that has a target date at or near your date of anticipated retirement, and then you allocate all of your retirement savings into that fund.

You get diversification and asset allocation included. Diversification is commonly heralded as a basic tenet of portfolio management. It may be a bit misunderstood and overhyped as to what it actually does, but it is important. Diversification helps reduce risk — and you should never take excessive risk. Asset allocation is a proven methodology of portfolio management which likewise helps manage risk across time. With target-date funds, you get a diversified portfolio managed via an asset allocation strategy.

Certainly you would get those things with an asset allocation fund. But the target-date fund brings with it the glide path approach of reducing portfolio level risk as the target date approaches. You simply can’t get a simpler way to invest your retirement nest egg.

What may be the target-date fund’s greatest contribution tends to be overlooked. Programmed investments reduce negative behavioral tendencies. The “set it and forget it” approach means that people are less likely to inadvertently cause harm to their portfolios by making emotional decisions in times of real or imagined crisis.

The human approach is reactionary. If an investment loses value, you sell it. If an investment soars, you buy more. The human approach virtually guarantees suboptimal returns. Emotions and herd mentality are not good catalysts for investment decisions. The “set it and forget it” approach has some very real advantages.

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Disadvantages of Target-Date Funds

The number-one disadvantage is the potentially higher cost. The structure of target-date funds is that of a fund of funds. The target-date fund purchases funds in each of the asset classes it wants to invest in. You have the underlying fund expenses of those funds plus the expenses of the target-date fund itself.

Note that this is a potentially higher cost. Some target-date funds use relatively low-cost index funds for their underlying investments and have modest overall fees. The real comparison needs to be against the other options available within your retirement plan. It really doesn’t matter what potentially near-zero fees may be out there in the world; your options are what’s available within your particular plan.

Target-date funds are rigid. They’re not designed to be a catchall investment vehicle to use for multiple goals.

Not unless all of your financial goals are going to occur at exactly the same time!

Not all target-date funds are created equal. If you look at portfolio composition for target-date funds with identical target dates, you’ll find quite a bit of variance between funds. You really need to research the options carefully to determine if the portfolio structure is appropriate for your needs both now and at the time of retirement.

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Operational Considerations

There are two major operational considerations with target-date funds. The first is the concept of using a target-date fund to the exclusion of other investments. The second is the narrowness of a specific target date.

A Target-Date Fund as an Exclusive Investment

The conventional wisdom is that you use a target-date fund as your exclusive investment vehicle for your retirement funding. The logic behind this wisdom is that introducing investments other than the target-date fund alters your investment allocation. Hence you shouldn’t do it. Ever.

Conventional wisdom can really screw you up.

The reason someone might elect to use one or more investments in addition to a target-date fund for their retirement funding is because it alters their investment allocation.

Conventional Wisdom vs. Reality

Conventional wisdom makes the dubious assumption that you’re a conventional investor. It is making the assumption — actually a plethora of assumptions — that you’re a middle-of-the-road, on-track, doing-everything-right-and-always-done-so type of investor.

Let’s say, hypothetically, that you’re not that investor. Let’s say you’re a wee bit behind on retirement funding. Perhaps your investments will never actually be sufficient for retirement. However, you’re investing to reduce the pain of being underfunded. Whatever the circumstances, let’s say you’re not completely the conventional investor.

Any asset allocation strategy is designed to minimize risk toward your objective. But minimum risk comes at a cost.

If you’re going to be underfunded for your retirement, you have a choice. Risk is a double-edged sword. You can elect to be aggressive in attempting to minimize your shortfall. This increases your risk of volatility and loss in your portfolio. But it also introduces the possibility of reducing your shortfall.

Or you can take minimal risk, reducing your chance of loss while assuring that you won’t have enough. Most people won’t consider assured failure the optimal solution.

Please don’t take excessive risk. That said, you know yourself and where you’re at. Maybe it makes sense for you to use a target-date fund for the bulk of your retirement portfolio, but invest a little bit into a couple of aggressive investments to try to jack your returns. Yes, it will definitely increase your risk of loss. But it also lowers the risk of running out too soon.

Conventional wisdom assures many people of insufficient retirement funding. They’re just not in a place to make that happen.

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Narrowness of Target-Date Funds

The other big operational consideration is the narrowness of the target date. Let’s revisit the comparison to education funding plans.

When planning for education, we typically anticipate needing the fund across a short period of time. Often four years, sometimes a little longer. We don’t plan on doing that with our retirement funds.

Retirement is a long-term goal not only in that there’s a bit of time to accumulate for it, but also in that there’s quite a bit of time when you may need to use the funds. The conventional wisdom is that you protect your nest egg by becoming quite conservative with your investments when you retire. As we discussed above, that can cause significant problems. The question is how do you deal with that when using a programmed investment that becomes very conservative at the time of retirement?

The conventional wisdom isn’t garbage, though. You just need to use it in context.

Conventional wisdom would have you take your lumps. But you could do things differently and try to improve your odds.

An Example

Let’s say you’re going to be a bit underfunded in retirement. The big danger is in overspending early and not having enough later in retirement. Inflation — even low levels of it — dramatically increases needs across long periods of time. We really do need to worry now about later retirement.

What if you defied conventional wisdom and invested a quarter or third of your retirement investments into a target-date fund with a target date at or near your retirement date, but then invested the balance into a target-date fund with a target date 20 years or so into your retirement? That would be unconventional. However, it could be appropriate if the risk of not having enough to last through your retirement is a larger concern for you than short-term volatility is.

You’d have a portion of your funds invested conservatively at the time of retirement and you could draw from those across the early years of retirement, stretching them to last until the second target date. Then you would have a larger pool for the higher-need portion of your retirement as you deal with inevitable increased costs.

Final Thoughts on Target-Date Funds in Retirement Planning

Target-date funds are a great way for investors to get exposure to equities with lower risk than that of pure equities. They get diversification and asset allocation and truly have a “set it and forget it” way to fund their retirements.

Technology is a great aid. But it doesn’t yet consider all the details of each situation. Conventional wisdom is designed to protect us from extreme behaviors that can hurt us. But we need to understand our own situations and why following conventional wisdom might or might not be appropriate.

As always, it’s important to do your homework. Some target-date funds are very expensive, while others are reasonable for what they provide. No investment will assure you a comfortable retirement, no matter what happens. But by making sound financial decisions you can make good choices that improve your chances within the framework of your tolerance for risk. And in many cases, target-date funds are a good tool to help with at least some of your retirement funds.

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