Westend61 | Westend61 | Getty Images
If you have a 401(k) plan — and about 60 million Americans do — chances are you are invested in a target-date fund. In fact, they are the default option for many plans, helping to explain why they make up nearly a quarter of 401(k) plan assets, according to the Plan Sponsor Council of America.
Of course, target-date funds are not limited to retirement plans. Financial advisors use them and so do many do-it-yourself investors.
Undoubtedly, such funds can be a handy tool, helping to make retirement planning easier. Yet, they aren’t a cure-all for everyone, with some investors likely finding themselves wanting more.
Here’s what you need to know.
Target-date funds tend to mature over five-year intervals, such as 2040, 2045 or 2050. The end date approximates when an investor plans to retire. They can take much of the guesswork out of retirement planning, with managers helping to ensure each fund has an age-appropriate mix of stocks and bonds by rebalancing the holdings over time.
More from Personal Finance:
78% of near-retirees failed or barely passed a basic Social Security quiz
Why Social Security beneficiaries may owe more taxes on benefits
62% of adults 50 and over have not used professional help for retirement
Besides the simplicity, another potential advantage is the fee structure. Passively managed target-date funds can have expense ratios as low as 0.08%. Admittedly, that’s higher than many exchange-traded funds and mutual funds that track indexes, but less expensive than actively managed options within the same fund family.
At their best, target-date funds are like a good meal kit service. Many people don’t know how, don’t want to or have the time to cook. So, they rely on a company to send them all the pre-portioned ingredients and directions they need to make a good dish.
Similarly, savers often have straightforward needs but neither the time nor know-how to construct a portfolio of investments that remain compatible with their risk profile throughout their adult life. For them, target-date funds can be a good option.
There are, however, some important caveats.
First, target-date holdings are sometimes too conservative for many younger investors. Consider that Vanguard and Fidelity’s version of a 2060 target-date fund is relatively bond-heavy — 9.7% and 13.32%, respectively — given they are intended for investors now in their 20s.
When you’re that young, the diversification benefits of fixed income — lower volatility and more consistent reinvestment rates — are largely theoretical. In reality, fixed income may only mute potential gains.
Secondly, the management approach may be too formulaic for many investors. For one thing, the composition of target-date funds and the reallocations that occur over time suggest the only thing determining an investor’s risk profile is how old they are. Many other factors go into that, including their assets and liabilities.
The other issue here is diversification. Vanguard’s 2060, 2050 and 2040 target-date funds devote at least 30% of their holdings to international investments, an area of the market that has underperformed U.S. equities for almost a decade and a half. Diversification is good, but diversification just for the sake of it can weigh on performance.
Finally, while passively managed target-date funds usually have reasonable pricing, actively managed ones can be expensive. For example, the Fidelity Freedom 2060 fund has an expense ratio of 0.75%, even as most planning-based financial advisors can come close to replicating its approach using less costly and potentially better-performing mutual funds and ETFs.
In the end, target-date funds are a mixed bag. For those with somewhat straightforward needs who perhaps don’t have a ton of investible assets nor the inclination to work with a financial advisor full time, they can be an economical way to invest and build wealth.
At the same time, target-date funds have some shortcomings, many of which highlight the value of a financial advisor — ironic given that asset management companies tout target-date funds’ ability to take some of the guesswork out of retirement planning.
Indeed, while no financial advisor can time the market to perfection and lock in outsize gains year after year, they can typically top the formulaic, rigid and somewhat uninspired approach many target-date fund managers tend to take.
— Andrew Graham, founder and managing partner of Jackson Square Capital
Don’t miss these stories from CNBC PRO: