Target-Date Funds – Is Yours Too Risky For You?

Many investors like the simplicity of using a target-date fund that automatically invests and rebalances the money they defer from their income into a retirement account. What may come as a complete surprise is that target-date funds are not created equal and may be more risky than many investors realize.

I know because I worked with target-date funds for years, managing millions of dollars for corporate 401k accounts. It wasn’t until I did a deeper dive looking at dozens of target-date funds that I realized the vast differences between funds with the same retirement target date. When I graphed my results, I was completely blown away. If you are one of those who invest your retirement dollars in a target-date fund, you need to keep reading.

Target-date funds are increasingly popular because of their simplicity and hands-off approach that many investors prefer. These professionally-managed funds contain a mix of stocks, bonds and cash equivalents that automatically rebalance based on the expected retirement date of the investor. As the fund gets closer to its specified target-date, say retirement in 2030, the investment allocation automatically becomes more conservative.

No two target-date funds are the same

The problem is that no two target-date funds are the same. Investors in different target-date funds who choose the same retirement date won’t necessarily reach that goal and beyond with the same level of risk. That’s why it is imperative for investors to make sure that the asset allocation and glide path are appropriate for the level of risk they want to take.

The formula for the change in asset allocation from ‘riskier’ investments, like stocks, to ‘safer’ investments, like bonds, is known as the funds “glide path.” Every target-date family has a different glide path based on what the company believes an average investor will want and need to succeed financially during retirement. It’s also one of the most important factors in determining the performance and the variability of their performance over the long-term.

In many 401(k) plans, the default investment option is a target-date fund, and in most cases, a plan only offers one family of these funds. This means that if you do not make an election when you enroll in the 401(k) plan, or if you are automatically enrolled, your money will be directed into the age-appropriate target-date fund. Although this fund will offer diversification, the asset allocation may not be what you want given your risk tolerance. In other words, two people who are the same age may have very different ideas of investment goals and risk tolerance, however, those two people will be defaulted to the same investment option.

Risk varies widely from fund to fund

The chart below shows the equity allocation of over thirty target-date funds with the retirement target of 2030. As you can see, the equity allocation ranges from approximately 40% to 85%. (Note: this does not include real estate and commodities, but rather domestic and international equities per Morningstar). The discrepancy here cannot be stated enough as the levels of risk vary widely from one 2030 target-date fund to another.

(The data compiled for this article comes from Morningstar which does a look through of each target-date fund to determine the asset allocation within it. Some of the assets are “unclassified” so while the results may not be exact, the ultimate point is that every target-date fund has a different and potentially unique DNA.)

Target Date Fund chart

Although the majority of the 2030 funds contain 65% – 75% equities, there are some clear outliers here. This is just another reason to do some due diligence and know exactly how your retirement assets are invested.

More risk doesn’t always mean more return

What’s even more interesting is the lack of correlation between the percentage of equity and the three-year annualized return.

For example, the Fidelity Advisor Freedom fund contains the highest amount of equities among its peers at 84% and the return was just over 11% per year. Contrast this with the Putnam fund which holds slightly over 50% equity and returned an average of 12% per year.

Choose the risk you want rather than the date

Before checking a box for the target-date fund nearest your retirement age, take a look at the amount allocated to stock funds. You may decide that you would rather have less or more risk. In that case, you may be better choosing one with a date that does not coincide with your expected retirement date. Outside of building your own portfolio, this may be the only way to invest in a target-date fund with an allocation that is appropriate for you.

Not only can target-date funds differ in terms of allocations and glide path, but the holdings within can also vary significantly. Most of these funds contain a mix of stocks, bonds and cash, and these may not meet the diversification requirements of every investor. As an example, one asset class missing from many of these families is alternative investments, which have become a staple in most portfolios.

Almost every 401(k) plan has an advisor assigned to it, and the cost of this is spread out among all participants. If you are paying for this advice, you should take advantage of it and become more informed before deciding how to invest your retirement money. Before slipping into this one-size-fits-all model and finding yourself in a portfolio that is either too aggressive or too conservative, take the time to make sure it’s the right choice for you.

Eric Dunner, J.D., CFP®
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