Is Your Target Date Fund Missing the Mark?

Are you counting on target date funds to get you to and through retirement? While popular and seemingly easy, many target date funds have inherent flaws that could actually work against your retirement goals.

Learn why you may want to reconsider relying on target date funds in retirement and what you can do instead in this short webinar. Edited transcript below.

Thank you for joining our investment webinar today – Is Your Target Date Fund Missing the Mark?
My name is Sammy Azzouz, I’m the President and CEO of Heritage Financial, a Boston-based wealth management firm managing over $2.4 billion for individual investors and families. Our team of 44 professionals helps people who are serious about their finances build smart-cost effective portfolios paired with detailed financial planning in an independent and fiduciary model.

Outside of my leadership responsibilities here at the firm, I serve on our investment committee and work closely with a select group of clients and enjoy building relationships with prospective clients who fit the firm’s approach.

As a follow-up to this webinar, you’ll receive some more information by email on how you can keep connected to our content and views.

Today, we’re going to focus on an important topic because the core of your retirement plan is likely your work 401(k) or equivalent plan, and Target-Date Funds have become a very popular way for people to invest and grow their retirement savings.
And they do a decent job at it, but they’re not without their flaws, particularly for a subset of pre-retirees for reasons you should be aware of.

Slide 2
First, what are target-date funds. They’re the ones in your 401(k) line-up with a calendar year somewhere in the name. The ACME Fund 2040 Target Retirement Date Fund, and usually there’s a long list of ones to choose from with target retirement dates 5 – 10 years apart.
And they’re considered all-in funds, meaning it’s a single fund that includes a mix of stocks, bonds, and short-term investments. The asset allocation mix adjusts based on an expected retirement date, with allocations growing more conservative as the fund’s target year approaches.
So, you start work, you’re 21 years old, you think you’ll retire at 65, so you pick the 2065 or 2070 target date fund and your new contributions and any match or profit-sharing money goes into there and you’ve outsourced the asset allocation and investment selection to the target-date provider.

Slide 3
As I mentioned, it’s an important topic because they’re very popular with 96% of plans offering them and 83% of participants using them.

Slide 4
Why?
For one, they’ve become the auto-default option on many retirement plans for new participants, which is a good thing as companies have moved more toward auto-enrolling employees in these important retirement plans and getting those participants into a target-date fund instead of them not contributing, or if they are contributing, being in the most conservative option.

They’re diversified. The typical target-date fund will own a broad base of stocks and bonds.

The target-date fund provider rebalances for you and makes asset allocation changes to the portfolio over time to account for the fact that you’re approaching retirement.

So, for a lot of investors – especially young investors just starting out where the funds will be growth-oriented and they don’t have a lot of time, interest or ability to manage their own money – they can be great.

Slide 5
But they also have some flaws that impact investors.

Slide 6
First, they have pre-determined glide paths. What does that mean? They’ve laid out already, years and decades in advance, what their asset allocation is going to be like in your portfolio. Showing you Vanguard’s glide path here as an example.

Looking at what I said earlier, for the young investors, early on heavy in stocks – US, then International, with some US bonds and international ones. A decent mix, although I can quibble with why someone 40 plus years out from retirement should own bonds, the young investor should be growth-oriented and they are here. But later on, as you’re adding more non-stock exposure to the portfolio, they’re not doing a good job building an asset allocation based on what’s going on in the market environment and what future expected returns would be.

Slide 7
We talk about our asset allocation approach at Heritage, through our blog at heritagefinancial.net and our Wealthy Behavior podcast. As a reminder, we use use capital market assumptions to build portfolios for clients focusing on expected ten-year returns. This is what we have in place this year. It’s showing just returns, but we’re also looking at risk and correlation metrics as well to build the strongest portfolio we can within a certain risk profile and then adjusting that allocation annually not because the end client is one year older but because the expectations have changed.
Look at bonds up top as a great example. Going back to the previous slide, we could be locked into our bond allocation regardless of whether bonds were attractive or not, or if you see how unattractive bonds were in 2022, you could underweight them in the portfolio and then subsequently add more in 2023 when the return expectations grew by a few percentage points per year.
That’s just one example. You could change your exposure between US and international stocks more frequently as well and the mix of stocks to bonds within reason.

Slide 8
Continuing with the bond story, if bonds weren’t attractive heading into 2022 and you don’t have a pre-determined glide path you don’t have to own as many and this gets us to another limitation with target-date funds – they’re diversified but missing important asset classes. Heading into 2022, real assets and alternative investments were attractive compared to bonds and we could allocate to them for our clients.

Slide 9
Pre-determined glide paths don’t allow for opportunistic adjustments.
Even though target-date funds take care of rebalancing for you, it’s programmatic and not based on opportunities that changes in the markets occasionally present investors.
Top half, as the market was declining in March of 2020, we saw it as a buying opportunity and increased stock exposure for clients and then as the market recovered we were able to trim down some of those purchases.
The same thing happened in 2016 and 2018.

Slide 10
Structurally, there are some challenges with Target-Date Funds as well.

Most funds are fund of funds, meaning you only get exposure to one fund family for all asset classes.

With fund of funds, there is likely an additional layer of fees for the fund family to put the fund together.

Could be paying high fees for index like returns as these target-date funds typically have a lot of mutual funds placed in them.

Slide 11
Then finally, you get to a financial planning concern I have with Target-Date Funds. Your investment strategy, meaning your approach and asset allocation, should be determined to a large extent by your financial plan. When will you start withdrawing from your investments and how much will you be withdrawing? That dictates the risk you can take, and how your assets should be invested.

With a Target-Date Fund not all retirees who have picked the 2045 fund as an example are in the same retirement planning situation. You may need to start withdrawing from your 401(k) right away, another investor can wait until Required Minimum Distributions start in their 70s. One person may need a small percentage of their 401(k) to live off per year, someone may need to take heavy withdrawals.

Your tax situation could dictate a different withdrawal strategy.

All of that is not being addressed with your target-date fund.

Slide 13 takeaways
Target-date funds have done much good, particularly for younger participants and new investors

As you add assets into the plan and approach retirement, their limitations may be too much to ignore

Build your own retirement strategy, starting with a detailed financial plan that can help build a more customized asset-allocation that can change with the market environment and as your situation changes

Slide 14

We can help. Heritage has built a detailed three-meeting process which we don’t charge for through which we help high net worth investors determine if we’re the right long-term fit for their family’s finances by learning about your goals, objectives and financial situation, analyzing how you’re currently positioned and sharing how we would bridge the gap between where you are and where you want to be in our state of the union meeting including a draft of a financial plan and then sharing specific planning recommendations and priorities and investment recommendations in our final meeting.

Slide 15

Thank you again for joining us. If there’s anything we can do to help you with your portfolio or wealth management needs, please contact me and hopefully you find the resources we’ll continue to share useful. You’ll also receive a short survey to help us make these webinars better for you. Thanks again. Have a great rest of the week.

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