Vanguard’s 2021 How America Saves report is in, and it reveals some interesting findings about how Americans plan for their retirement. Among the biggest trends is the use of target-date funds to grow retirement wealth. According to the report, 95% defined-contribution plan sponsors offered target-date funds as an investment option for plan participants.
“Target-date funds are typically more attractive for 401(k) plan administrators because these securities remove the responsibility of reallocating the portfolio from the plan administrator,” says Brett Tharp, senior financial planning analyst at eMoney Advisor.
- The potential for better returns and lower fees make target-date funds attractive to investors who want to take a hands-off approach to their retirement portfolio.
- Automatic enrollment and assignment to a default investment strategy both help explain why target-date funds have been surging in popularity.
- Putting your retirement funds on autopilot with target-date funds has two downsides: the investments may be either too conservative or too risky for you, and going on autopilot can encourage a disconnect from your portfolio and your goals.
According to Vanguard’s report, 80% of workers enrolled in a 401(k) or similar defined contribution plan use target-date funds, and two-thirds of participants who use a target-date fund strategy have their entire account invested in a single fund. While target-date funds can simplify your retirement plan, making them the focal point of your investment strategy could backfire.
“Conceptually, target-date funds are great; they automatically rebalance as you get older and closer to retirement,” says Tony Drake, CEO and founder of Drake & Associates in Waukesha, Wis. “However, having 100% of your holdings in a single fund may be overdoing it.”
If your retirement plan currently includes target-date funds or you’re considering them, it’s important to balance their pros and cons.
Weighing the Merits of Target-Date Funds
Target-date funds have certain merits compared with other mutual funds or investments, starting with their return potential. According to research from Alight Solutions covered by Pension & Investments, target-date funds delivered an average annualized return of 3.66% for defined-contribution plan participants who consistently used managed accounts. The average for consistent non-users was 3.39%, by comparison.
In other words, defined-contribution plan participants who remained enrolled in a target-date fund on a regular basis earned better returns than participants who invested in these funds only sporadically or not at all.
Target-date funds can also be more investor-friendly from a cost perspective. According to data from Morningstar reported on by Vanguard, the average asset-weighted expense ratio for target-date funds fell to 60 basis points in 2019.
Meanwhile, investors are finding target-date funds with much lower expense ratios. In 2008, the average expense ratio paid by investors was 0.67 percent. In 2020, that number had decreased to 0.37 percent.
The potential for better returns and lower fees may look attractive if you’re trying to grow retirement wealth, particularly if you prefer an approach that doesn’t require you to be extremely hands-on with your investment choices. “Target-date funds are a simple solution for people who either don’t want to deal with investing or who are intimidated by money,” Drake says.
Target-date funds are also a more comprehensive way to choose investments rather than solely reviewing a fund or stock’s past performance.
Another plus is that target-date funds adjust their asset allocation automatically over time, based on your desired retirement date, relieving you of the burden of selecting individual investments that align with your goals and risk tolerance.
“Many investors are not aware or simply forget to change their allocation,” Tharp says. “Target-date funds help mitigate and reduce this risk.”
A Prime Target for Retirement Investors
There are some solid reasons to invest in target-date funds, but Vanguard’s report sheds some light on why they now account for such a large share of defined contribution plan participants’ portfolios. The answer is very simple: automation.
According to Vanguard, the adoption of automatic enrollment has tripled since year-end 2007. By 2020, more than half of Vanguard plans had adopted automatic enrollment, and 74% of new plan participants (with at least 1,000 participants) were enrolled automatically. More important, 99% of plans with automatic enrollment automatically assign plan participants a default investment strategy, with 98% of plans choosing a target-date fund as the default.
But while automatic enrollment in a target-date fund may sound attractive if you want to keep retirement planning simple, there are some potential downsides.
Two-thirds of automatic enrollment retirement plans have put into place automatic annual increases in participants’ deferral rates, according to the Vanguard report.
The Problem With Putting Your 401(k) on Autopilot
The biggest issue with target-date funds is that they only focus on one variable: your retirement age. Keith Clark, managing partner of DWC—The 401(k) Experts, says that defined-contribution plan participants should focus on at least three variables: their contribution rate, company matching contributions or profit-sharing, and how much progress they’ve made thus far toward their retirement goals.
“Participants control two variables, their contributions and their investment selections,” Clark says.
But the problem with utilizing target-date funds by default is that your portfolio may end up being too conservative to produce the kind of returns you’re looking for or place you at too much risk.
Being automatically enrolled in target-date funds can also lead to a disconnect when it comes to what’s happening in your portfolio.
“Not paying attention to your retirement plan is always a downside,” Clark adds. “At minimum, you should be reviewing your retirement account once a quarter to ensure accuracy of all transactions and at least annually to determine where you stand in relation to your retirement goals.”
That includes checking the fees you’re paying for target-date funds or other investments. The higher the fees, the fewer returns you get to keep.
The Bottom Line
Determining whether target-date funds are a good fit hinges largely on understanding what type of investor you are, according to Tharp.
“Target-date funds might be beneficial to investors who are hands-off and don’t want to worry about managing their portfolios,” says Tharp. However, “investors who follow the market closely and enjoy constructing and reallocating their portfolios may want to consider alternative options.”
If you plan to pursue target-date funds in your retirement plan, remember that they’re not all created equally. “Target-date funds look different with each provider,” Drake says. “They’re made up of different percentages of equities, and some are actively managed while others are entirely index funds.”
Target-date funds may offer simplicity, but at the end of the day, you must still do your homework to ensure that you’re steering the right course with your employer’s retirement plan.