The Hidden Risks of Target Date Funds: A Guide to Smarter Retirement Investing

Target-date retirement funds have become increasingly popular within employer-sponsored retirement plans in recent years, offering investors a seemingly simple “set it and forget it” approach to retirement planning. However, the static nature and inflexible asset allocation of these funds can present significant downsides for many investors. This article explores the potential drawbacks of static target date funds and why a more flexible approach to retirement investing may be beneficial.

1. The Illusion of Simplicity

Target date funds are designed to automatically adjust their asset allocation as an investor approaches retirement, typically becoming more conservative over time. While this approach may seem convenient, it oversimplifies the complex and highly personal nature of retirement planning.

2. One-Size-Fits-All Approach

One of the main drawbacks of static target date funds is their one-size-fits-all approach1. These funds base their investment strategies solely on an anticipated retirement date, without considering an individual’s unique financial circumstances, risk tolerance, or retirement goals. As a result, the fund’s asset allocation may be too conservative or too aggressive for many investors.

3. Lack of Personalization

Every investor has different needs, goals, and risk tolerances. Static target date funds fail to account for these individual differences, potentially leaving investors with portfolios that are misaligned with their specific requirements. For example, a high-income earner with substantial savings may benefit from a more aggressive allocation even close to retirement, while someone with a lower risk tolerance might prefer a more conservative approach earlier on.

4. Inflexibility in Changing Market Conditions

The rigid nature of static target date funds can be problematic in the face of changing market conditions and economic environments.

5. Limited Adaptability

Target date funds follow a predetermined glide path, gradually shifting from stocks to bonds as the target date approaches. However, this inflexible approach doesn’t allow for adjustments based on market conditions or economic factors. In periods of high inflation or low interest rates, for instance, the fund’s allocation to bonds may not provide adequate protection or returns.

6. Missed Opportunities

The inability to adapt to market conditions can result in missed investment opportunities. During market downturns, for example, a more flexible approach might allow for increasing equity exposure to take advantage of lower prices. Static target date funds, however, will continue to follow their predetermined path regardless of market conditions.

7. Potential for Suboptimal Returns

The conservative shift in asset allocation as retirement approaches can lead to suboptimal returns for many investors.

8. Excessive Conservatism

Research has shown that many target-date funds become too conservative for most people around the age of 50. This shift towards a more conservative allocation may unnecessarily limit growth potential, especially for investors who have a longer investment horizon or those who don’t plan to withdraw all their funds immediately upon retirement.

9. Longevity Risk

With increasing life expectancies, many retirees need their portfolios to continue growing well into retirement. The overly conservative allocation of many target date funds in later years may not provide sufficient growth to sustain a long retirement, potentially exposing investors to longevity risk – the risk of outliving one’s savings.

10. Higher Fees and Lower Transparency

Static target date funds often come with additional costs and reduced transparency compared to other investment options.

11. Elevated Expense Ratios

Target date funds typically have higher expense ratios than simple index funds, partly due to the active management involved in adjusting the asset allocation. These higher fees can significantly impact long-term returns, especially when compounded over many years.

12. Limited Visibility

The complex structure of target date funds, which often invest in other funds (fund of funds), can make it difficult for investors to understand exactly what they own. This lack of transparency can hinder informed decision-making and make it challenging to assess the true level of diversification within the portfolio.

Alternatives to Static Target Date Funds

Given the limitations of static target date funds, investors may want to consider alternative approaches that offer more flexibility and personalization.

Utilize Model Portfolios

Many employer-sponsored retirement plans offer model portfolios which are pre-designed investment strategies that offer a diversified mix of assets tailored to specific risk tolerances and investment goals.

Key Features

• Diversification: Model portfolios offer a diversified group of assets aimed at achieving an expected return with corresponding risk.
• Risk-Based Options: Most plans offer multiple model portfolios to match different risk tolerances and investment goals, such as conservative, moderate, or aggressive portfolios.
• Automatic Rebalancing: Many model portfolios include periodic rebalancing to maintain the intended asset allocation.

Benefits for Participants

• Simplicity: Model portfolios simplify the investment decision process for employees who may not have the time, knowledge, or desire to manage their retirement investments.
• Personalization: Participants can choose a portfolio that aligns with their risk tolerance and investment timeline.
• Time-Saving: Using a model portfolio can free up time for participants to focus on other aspects of their financial planning.

Considerations

• Limited Customization: While model portfolios offer some level of personalization, they may not be as tailored as professionally managed accounts (See Below).
• Periodic Assessment: Participants may need to reassess their risk tolerance and goals periodically to ensure they remain in the appropriate model portfolio.
• Potential Limitations: Some plans may restrict mixing model portfolios with other investment options.

Choose Your Own Investment Allocations

If you are comfortable managing your retirement investments, you can create a more personalized investment portfolio with the available investment options within your employer-sponsored plan based on your individual goals, risk tolerance, and financial situation can provide a more tailored approach to retirement planning than simply choosing a target date fund option.

Considerations

• Limited Customization and Market Knowledge: The level of customization will depend on the number and type of investment options available and an investor’s understanding of which options would be most suitable for their goals,  risk tolerance, time horizon, and current market and economic conditions.

• Periodic Assessment: Participants may need to reassess their risk tolerance and goals periodically to ensure they remain in the appropriate funds and rebalance as appropriate.

• Potential Limitations: Some plans may restrict mixing model portfolios with other investment options.

In-Service Withdrawals and Managed Account Options

Many Employer-Sponsored Retirement plans, including 401(k), 403(b) plans, and the Federal Employees Thrift Savings Plan (TSP) allow employees who have reached age 59 ½ to transfer some/or all of their retirement plan assets while they are still employed to an IRA that can then be professionally managed.

An often overlooked but important benefit, non-taxable In-Service withdrawals (to an IRA) allow those nearing retirement to take more control over their employer-sponsored retirement plan funds. How your retirement funds are managed in the final few years leading up to retirement can have an outsized impact on an employee’s ability to achieve their retirement income and lifestyle goals.

In addition, some 401(K) plans offer Managed Account Options, regardless of age, like Fidelity Brokerage Link®, which can significantly enhance an employee’s ability to invest their retirement funds by providing access to professional money management through fee-based registered investment advisors who as fiduciaries are bound to act in their client’s best interests.

Both In-Service Withdrawals and Managed Account Options offer several key benefits:

• Expanded Investment Options

In-Service Withdrawals and BrokerageLink® can dramatically increase the range of investment choices available to employer retirement plan participants. While standard employer retirement plans typically offer a limited selection of mutual funds, an In-Service Withdrawal to an IRA and BrokerageLink® opens up access to a much broader universe of securities, including individual stocks, bonds, exchange-traded funds (ETFs), and a wider array of mutual funds. This expanded selection allows for more sophisticated and tailored investment strategies.

• Professional Management Opportunities

One of the most significant advantages of In-Service Withdrawals/Rollovers and BrokerageLink® is the ability to have your employer-sponsored retirement plan account professionally managed. This feature is particularly beneficial for investors who:

1. 1. 1. Lack the time or expertise to manage their 401(k, 403(b) or TSP investments
      2. Prefer a more hands-on approach to retirement planning
      3. Want to leverage the knowledge and experience of financial professionals

By allowing third-party advisors to manage their IRA or BrokerageLink® account, investors can benefit from:

• • Personalized Investment Strategies

Professional money managers can create customized investment strategies that
align with an individual’s specific financial goals, risk tolerance, and investment horizon. This level of personalization is often not possible with the standard options offered in most employer-sponsored retirement plans.

• • Potential for Enhanced Returns

With access to a wider range of investment options and professional management, there is potential for improved investment performance. Skilled advisors can identify opportunities that may not be available through standard employer retirement plan offerings and can adjust strategies to take advantage of market conditions.

• • Risk Management

Professional managers can help mitigate risk through proper diversification and strategic asset allocation. They can also provide valuable insights into market trends and potential risks, helping investors make more informed decisions about their retirement savings.

• • Ongoing Oversight and Adjustments

Unlike set-it-and-forget-it target-date funds, professionally managed accounts receive continuous oversight. Managers can make timely adjustments to the portfolio based on changing market conditions or shifts in the investor’s circumstances.

• • Potential Cost Efficiencies

While there may be additional fees associated with professional management, advisors may be able to identify more cost-effective investment options within a professionally managed IRA and  BrokerageLink® platform. This could potentially lead to lower overall expenses compared to some standard employer-sponsored retirement plan offerings.

In summary

While static target date funds offer simplicity and convenience, their inflexible asset allocation and one-size-fits-all approach can be detrimental to many investors’ retirement goals. The potential for suboptimal returns, lack of personalization, and inability to adapt to changing market conditions are significant drawbacks that should be carefully considered.

Investors can potentially enhance their retirement investment strategies by adopting more flexible and personalized investment approaches including:

1. Model Portfolios: Many employer-sponsored plans have Model Portfolios that can be aligned with an investor’s risk tolerance and investment goals.
2. Custom Asset Allocation: Investors can research and choose their own mix of available investment options with their employer-sponsored retirement plan.
3. Professional Management Options:

For those aged 59½ and above: Consider In-Service Withdrawals, if offered, to transfer a portion of your employer-sponsored retirement plan to a professionally managed IRA.

For all ages: Explore using Fidelity’s BrokerageLink®, if offered, which allows for professional money management of your employer-sponsored retirement plan assets while broadening your investment options.

These approaches offer the potential for more customized investment strategies, professional oversight, and the flexibility to adapt to market changes while you are still employed. By aligning investment choices with individual needs and goals, investors may be better positioned to achieve their retirement objectives.

 

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The information provided in this article is for educational and informational purposes only. It should not be construed as investment advice or a recommendation to buy, sell, or hold any specific security or investment product. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal. Before making any investment decision, you should carefully consider your financial situation, risk tolerance, and investment objectives. We strongly recommend consulting with a qualified fiduciary financial advisor to discuss your specific circumstances and determine the most appropriate investment strategy for your individual needs and goals.