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Lack Of Precision Can Hurt Target Date Funds

Since the inception of the 401(k) plan more than 40 years ago, employers have faced a consistent challenge: enticing more of their employees to start saving for retirement. Recent efforts have focused on simplifying the enrollment and fund selection process, giving rise to the newest savings plan innovation: the target date fund. The popularity of these funds speaks to their simplicity and convenience but, as with many things in the investing world, these benefits may come with some hefty tradeoffs.

For the uninitiated, a target date fund enables an investor to select a time frame for the investment that corresponds to a specific event in the future, such as retirement. The fund automatically adjusts the mix of assets to become more conservative as the target date approaches, meaning that the investment should be most secure when the funds are most likely to be needed. Sounds like a good idea, right? A brilliant concept for sure, but one that can lose much of its shine when put into practice. Here are some of the more common concerns cited by experts in the business.

Square peg, round hole – Target date funds by their very nature take a “one-size-fits-all” approach to investing. Although time horizon is a major factor, personal goals and tolerance for risk are equally important when developing an investing strategy. The fact that you want to retire in 20 years does not necessarily mean that a 2035 target date fund is the best investment option.

Black box – Managers of target date funds give themselves lots of latitude on the type of investments contained in the fund, and the mix of those investments over time. Two funds with the same target date can have vastly different underlying investments, investing strategies and risk profiles. Not only do investors forfeit control over the investing decisions, they often can’t even see what’s in the portfolio. Essentially, they’re just along for the ride.

Performance drag – Target date funds are actively managed and often invest in mutual funds offered by the same financial institution. In many cases, these underlying funds are actively managed as well, resulting in higher trading costs and expense ratios than well-established index funds offered by companies like Vanguard and Fidelity. Over a long time horizon, these additional costs can have a huge impact on portfolio performance and value.

Glide path – Every target date fund has a unique glide path, which is the pace at which the fund transitions from a more aggressive mix of assets to a more conservative one over time. This is one of the most important determinants of risk and return, but it is often overlooked by the investor. More importantly, investors tend to focus on getting to retirement, when in fact their investment portfolio needs to get them through retirement. A very conservative portfolio at age 65 might not serve the retiree well over a time horizon of 20 or 30 more years.

In today’s hyper-connected world of Google searches and “one-click” purchasing, simplicity and convenience weigh heavily on our decision-making. But the rules of successful investing haven’t changed. We still need to balance risk and return, know what we own, and pay close attention to cost. A target date fund might be the best choice for your portfolio, but only if that choice is made for the right reasons.

Kevin Fix