From the May 2013 issue of Research Magazine • Subscribe!

Beware of Target-Date Funds

I think any advisor who recommends or sells a TDF is out of their mind.

Almost one in four 401(k) participants invest solely in target-date funds—a six-fold increase over the past five years. And assets in TDFs have bulged to approximately $475 billion.

Yet, despite the growing popularity of TDFs, flaws with these types of investments abound. Let’s examine just a few of them:

TDFs encourage people to be lazy. A person’s first choice for their retirement investments should never be a canned asset allocation default solution. Instead, we should be encouraging investors to have a customized investment mix that perfectly matches them. That includes a plan that accounts for their age, risk tolerance, and goals rather than a one-size-fits-all retirement fund.

TDFs don’t properly tackle the issue of longevity. Living beyond one’s financial resources is a serious problem that faces millions of retirees. A TDF that switches the bulk of its allocation to bonds when a person reaches the standard retirement age range of 65-70, may subject these individuals to very large inflationary risks should they end up living longer than they expect.

TDFs undermine the crucial role of professional investment advice. If the main purpose of a TDF is to help 401(k) savers to get the right asset mix, of what value are financial advisors who provide the same service? When I worked as a financial advisor, I never recommended TDFs because I recognized the threat they posed to the personalized investment advice I was giving to my clients. And now, as an outside observer, my views haven’t changed. I think any financial advisor who recommends or sells a TDF is out of their mind.

TDFs are not adequately diversified. No matter what fund companies say, most TDFs are grossly underdiversified because they miss market exposure to major asset classes like commodities, global real estate, international bonds and TIPS. Various academic studies show that exposure to stocks and bonds alone is not true diversification.

Few Choices

A new research study titled, “Target Date Funds: Still Off Target?” by Marc Fandetti of the Meketa Investment Group closely examines the many problems with TDFs. The study reveals that there are disappointingly few choices for investors at or in retirement and seeking a relatively conservative TDF choice.

Fandetti suggests that plan sponsors should consider alternatives, such as customized TDF solutions. And I think he’s on to something.

Although it may be true that a TDF default choice is better than nothing, it’s not a better choice than a customized investment mix that perfectly matches a 401(k) participant’s unique investment needs. And that’s something that only a financial advisor can offer.

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