Target Date Funds: Hidden Risks in Your 401k?
If you’ve got a retirement plan at work, like a 401(k), there’s a pretty good chance that some of your investment options include something called target-date funds.
The idea behind a target date fund is fairly simple: You pick a fund with a target year that’s closest to the year you anticipate retiring or needing the money. If you expect to retire in ten years, you might use a “2030 Fund.” If you don’t expect to retire for 20 years, a 2040 fund might suit your needs. As you move toward your retirement “target date,” the fund gradually reduces risk by changing the investments within the fund. They are kind or a “Set-it-and-forget-it” fund with someone else doing all the work for you.
Most target-date funds are structured as what’s called a “fund of funds,” meaning that they invest in other mutual funds rather than in individual securities. They’re designed to create an appropriate allocation of risk and reward based on the date listed on the fund. So a 2030 fund may have a different (presumably less risky) allocation of stocks and bonds than, say, a 2050 fund, because the year 2050 is about 30 years away, and 2030 is just eight years away. The idea is that the closer you get to that target date, the more conservative the fund’s allocation should become.
Risks Associated with Target Date Funds
Having said that, though, target-date funds are not risk free, even when your target date has been reached. Funds with identical target dates may, in fact, have completely different investments and risk profiles, and target-date funds can lose money if the stocks and bonds owned by the fund drop in value. In fact, Morningstar says that back in 2008, funds with a 2000–2010 target date lost an average of 22%! So the date actually means very little — it’s simply the date that the fund is basing its risk and reward model on.
And that target date also doesn’t consider the rest of your portfolio (which may include other stock and bond investments, thus throwing your overall allocation off-kilter).
Another risk is that it can be very difficult to determine what’s in the funds and how they’ll perform in any given circumstance. As I mentioned earlier, funds that sound similar may have wildly different investments and risk profiles across various companies. You need to know what the fund’s actual allocation of stocks, bonds, and cash is before you invest.
Something else to be aware of is that with most target-date funds, once the target date is reached, the portfolio model no longer changes its allocation. This means that if the fund is, say, 80 percent invested in bonds at the target date, it’s going to stay that way until you sell the entire fund. And if interest rates rise, that can put your portfolio at risk. I’ve said this before: according to the research, a rising glide path of stocks post-retirement – meaning owning MORE stocks as you age through retirement – may give you much better results.
Target Date Fund Fees
And finally, you should consider the fees. The average target-date fund had an expense ratio of 52 basis points in 2020, which means if a fund had a 7% gross return before fees, the net return you’d see after fees is 6.48%. Not terrible, but not great. These fees can really add up over time, and for target-date funds that are “funds of funds,” which usually have hidden fees in the investments they hold, they can be even higher! If you’re concerned about that, you should check around for target-date funds with lower fees.
All of this is not to say that target date funds are bad. They may work really well for people who want something simple, and who maybe have a long time horizon before retirement. You just need to consider the risks before you invest in them. Because even something that seems simple can turn out to be complicated and expensive.
One strategy note here: if you decide to use a target date fund, don’t put your ongoing salary deductions into one that’s based on your retirement date – use dollar-cost averaging to your advantage and put any NEW ongoing contributions into the one with the longest target date.
Right now may be a good time to go over your 401k allocation with your financial advisor and see if your asset allocation and risk profile are in sync with your goals. We do this every single day at Lucia Capital Group. How can we help you? Just give us a call!
The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy will be profitable for a client's or prospective client's portfolio, thus, investments may result in a loss of principal. Accordingly, no client or prospective client should assume that the information presented serves as the receipt of, or a substitute for, personalized advice from LCG or from any other investment professional.
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Target-date funds are subject to the volatility of the financial markets, including equity and fixed-income investments in the U.S. and abroad, and may be subject to risks associated with investing in high-yield, small-cap, and commodity-related, foreign securities. Principal invested is not guaranteed at any time, including at or after target dates.
Before investing, carefully consider a target-date fund’s investment objectives, risks, charges, and expenses. To obtain a prospectus or summary prospectus, which contains this and other information, call your financial advisor. Read the prospectus carefully before investing. The principal value of a target fund is not guaranteed at any time, including at the target date.
It is important to keep in mind that investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk and special tax liabilities. Interest may be subject to the alternative minimum tax. Treasury securities are backed by full faith and credit of the U. S. Government but are subject to inflation risk.
A dollar cost averaging strategy does not guarantee a profit or protection from loss. Since such an investment plan involves continual investment in securities regardless of fluctuating price levels, you must consider your willingness to continue purchasing during periods of high or low-price levels.
Rick Plum is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor and member FINRA/SIPC. The investment professionals are affiliated with LPL Financial and are conducting business using the name Lucia Capital Group, a separate entity from LPL Financial.