Target-Date Pros and Cons

Note: This article is part of Morningstar's January 2014 401(k) Week special report. 

Question: My employer offers a target-date fund option as part of our 401(k) plan. The convenience factor is a big plus, but I'm a little nervous about putting all of my eggs in one basket. Can you help me sort out the pros and cons of using a target-date fund for my retirement savings?

Answer: Interest in target-date funds has grown tremendously in recent years as have the amount of assets flowing into these all-in-one retirement-savings vehicles. At the end of 2013 more than $600 billion was invested in target-date funds, more than double the amount invested in them just four years earlier. One reason for this dramatic growth: companies auto-enrolling employees into their 401(k) plans and investing the assets in target-date funds based on the employee's age. (Of course, market appreciation has played a big role as well.)

So how do target-date funds work, and why have they become so popular?

Unlike regular mutual funds, in which a portfolio manager invests fund assets in a collection of securities--stocks, bonds, and so forth--a target-date fund typically is a fund-of-funds, meaning that its portfolio is made up of other, more specialized funds. For example, a target-date fund might own a domestic stock fund, an international stock fund, and a bond fund, allocating assets in a way that makes the most sense given the investor's age.

So a target-date fund designed for investors nearing retirement who don't have time to ride out stock market volatility may tread lightly in stocks and heavily in fixed-income investments. But for investors who are three or more decades away from retirement, and who have plenty of time to ride out the market's ups and downs, a target-date fund is typically weighted much more heavily toward stocks, since they offer better long-term return potential compared with bonds and other fixed-income investments.

About Those Names
You'll notice that target-date funds typically have a year as part of their name, which indicates that the fund is built around an allocation appropriate to investors expecting to retire that year. So, for example, the  Vanguard Target Retirement 2025 (VTTVX),  Fidelity Freedom 2025 (FFTWX), and  T. Rowe Price Retirement 2025 (TRRHX) funds all are designed for investors who expect to stop working around the year 2025. These and other target-date series typically offer funds designed for investors with different time horizons and spaced at five-year intervals. For instance, the Vanguard Target Retirement 2025 fund holds about 70% of assets in stocks, whereas the  Vanguard Target Retirement 2035 (VTTHX) fund holds nearly 85%, and the  Vanguard Target Retirement 2045 (VTIVX) fund holds nearly 90%.

That said, not all target-date funds for a given year use the same allocation. Some invest more heavily in stocks throughout the life of the fund in the belief that a higher equity position--and the higher returns that typically come along with stocks--is necessary to ensure that investors don't outlive their savings. Others hold a relatively smaller percentage of assets in stocks in an effort to avoid excessive risk and tamp down volatility. For example, T. Rowe Price Retirement 2025 currently holds about 75% of assets in stocks, whereas  BlackRock LifePath 2025 (LPBAX) holds just 50%.

The rate at which a target-date fund adjusts its allocations to stocks and fixed income over time is known as its glide path. Some target-date series use glide paths that consistently keep the allocation to equities on the high or low side relative to their peers, while others start high and then take a steeper path toward a more balanced allocation. (For a comparison of target-date series glide paths, see Page 16 of Morningstar's 2013 Target-Date Series Research Paper.)

Target-Date Pros and Cons
Whether a target-date fund is the best choice for you depends on a few different factors, including the degree to which you want to manage your own retirement portfolio. Below are some pros and cons of using target-date funds.

Pros
One-stop shopping: For an easy-to-use, all-in-one retirement savings vehicle, a good target-date fund is tough to beat.It allows investors to focus on one of the most important pieces of the retirement savings puzzle--how much to save--rather than getting bogged down in making investment decisions. Target-date funds also have a good track record with respect to how investors use them, which is to say that target-fund investors tend to buy and hold the funds rather than moving assets in and out of them in an attempt to time the market.

Professionally managed allocations: Fund shops typically put a great deal of thought into the design of their target-date series to ensure that it is well-suited to the needs of the typical investor. That doesn't mean target-date funds are perfect, though. Some used allocations that were overly aggressive when the 2008 market crash hit, resulting in heavy losses for their investors, including those who were close to retirement. Also, target-date fund asset allocations essentially are one-size-fits-all propositions. For customized allocation advice, you might be better off with a financial advisor who can tailor a retirement plan to your situation.

Automated adjustments: Unlike other investment vehicles--including allocation funds that hold both stocks and bonds--target-date funds adjust their allocations automatically as the investor's retirement date approaches. No other commercially available investment product is designed to do this.

Reasonable fees: Target-date fund fees are generally in line with those of other mutual funds, with an asset-weighted average expense ratio of 0.91% in 2012. However, unlike conventional mutual funds, target-date funds have a built-in asset allocation feature. Also, target-date funds built around index funds tend to be cheaper than those built around actively managed funds.

Cons
Lack of control: For investors who want more control over their investment or allocation choices, target-date funds might not be the best option. By choosing one, you are essentially limiting yourself to a given fund family's funds and allocation framework, and few fund companies offer best-of-breed funds across all asset classes. Some investors may not welcome these constraints. If you'd rather build your own retirement portfolio, choosing the investments you want and managing them accordingly, target-date funds probably aren't for you.

Added complexity if used with other holdings: As an all-in-one vehicle, target-date funds are built to serve as the only retirement holding you need. However, if you'd rather not put all your retirement savings into a target-date fund and/or wish to add satellite holdings--perhaps to add exposure to market sectors not represented in the target-date fund's portfolio--these additional holdings will mean recalculating the asset allocation of the entire retirement portfolio yourself to make sure it's in line with your needs. (Morningstar's Portfolio X-Ray tools can help with this.) The fact that the target-date fund's allocation changes over time adds additional complexity.

In-retirement shortcomings: Target-date funds can be effective as savings vehicles, but once the account holder reaches retirement, they may become inadequate. For example, those hoping to use assets invested in a target-date fund to generate income to cover living expenses in retirement may be disappointed. In fact, many retirement series put target-date investors into conservatively invested retirement income funds once the retirement date is reached, and many of these retirement income funds currently yield well under 2%.

Also, as Christine Benz, Morningstar's director of personal finance, points out in this article, target-date fund investors who are in retirement and taking distributions don't have the flexibility to sell specific assets that have appreciated and may be ripe for a fall. Rather, by selling or taking distributions from the fund, they essentially are reducing their exposure to all asset classes in equal proportion.

Despite these potential drawbacks, for many investors a target-date fund is a great choice to save for retirement provided it comes from a quality fund shop and operates using quality parts--that is, quality underlying funds. Even then, understanding the target-date fund's glide path remains important so that you don't end up with a target-date fund that takes on too much risk, or not enough, for your comfort zone.

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