Are Target Date Funds, the Most Popular 401(k) Investment, Right for You?

Target-date funds are a way for 401(k) participants to put their retirement savings on autopilot—and they capture the lion’s share of investor contributions to 401(k) plans.

As of 2023, about 29% of assets in the average 401(k) plan were held in TDFs, according to the Plan Sponsor Council of America, a trade group. That share is the largest of all fund categories and is up from 16% in 2014, according to PSCA data.

By 2027, roughly 66% of all 401(k) contributions will be in target-date funds, and about 46% of total 401(k) assets will be in TDFs, according to a 2023 estimate from Cerulli Associates, a market research firm.

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That popularity is largely due to employers’ widespread acceptance of TDFs as the default investment for employees automatically enrolled in their company’s 401(k) plan.

While the funds bring benefits to many investors, they can also have drawbacks to others, financial advisors said.

“Target funds have a place for some investors, but they certainly are not and should not be used for everyone,” says Winnie Sun, managing partner of Sun Group Wealth Partners, based in Irvine, California, and a member of CNBC’s Financial Bank. Advisory Council.

Financial experts generally advise investors to reduce their savings as they age – usually by moving from more aggressive and volatile investments such as stocks to more stable investments such as bonds and cash.

TDFs do this automatically, based on an investor’s estimated retirement year.

For example, a 35-year-old investor who expects to retire within 30 years would likely choose a 2055 fund. A 55-year-old can choose a fund for 2035. The funds are typically provided in five-year increments.

The fund’s asset allocation slowly becomes more conservative in the years leading up to, and sometimes after, that retirement year.

Proponents often tout the simplicity of TDFs, known as a one-stop shop for 401(k) savers who may not have the time or knowledge to adequately manage a customized portfolio.

“From where I sit, target-date funds are nothing short of the biggest positive for investors since the index fund,” said Christine Benz, director of personal finance and retirement planning at Morningstar. wrote in June.

They make key decisions, such as asset allocation and investment selection, “completely out of the hands of investors,” Benz wrote.

TDFs are cheap and reasonable investment advice for people who may not be able to afford to hire an advisor and who are prone to making “crazy” investment choices, she wrote. TDFs also discourage behavior known to erode investor returns, such as buying high and selling low, she added.

“They are designed to be easier-to-manage investments for those who simply prefer simplicity and greater convenience,” Sun said.

However, there are some reasons why TDFs may not work for certain investors, especially those with sufficient savings outside their 401(k) plan or who want to take a more hands-on approach, advisors say.

First, just because investors expect to retire around the same age doesn’t mean the same asset allocation is right for all of them.

“What if you are more conservative or instead prefer more growth, aggressive technology investments, or prefer to invest in socially responsible investments?” said Sun.

Asset managers have different investment philosophies. For example, certain fund families may be more aggressive or conservative than others.

Employers generally only offer TDFs from one financial firm, and the funds offered may or may not match an investor’s risk profile, experts said.

“It’s important for someone to understand how much risk they are taking on in their target date fund,” says Carolyn McClanahan, a certified financial planner and founder of Life Planning Partners in Jacksonville, Florida.

“For example, you would think that a 2030 target date fund would be allocated conservatively, but most are 60% equities because they assume you’ll withdraw those funds over a long period of time,” says CNBC member McClanahan. Advisory Council.

Investors may be able to build a lower-cost portfolio on their own by using a mix of index funds, although this approach would require more work on the part of investors, she said.

Additionally, TDFs do not allow “tax location” of different assets, McClanahan said.

This aims to increase after-tax investment returns by strategically holding stocks and bonds in certain types of accounts.

For example, assets with high-growth potential are well suited to Roth accounts because investment returns are generally tax-free in retirement, McClanahan said.

Experts also generally recommend holding many bonds and bond funds in tax-deferred or tax-exempt accounts.

Despite the shortcomings for certain investors, “Do target date funds help investors who are unaware of the basics of investing find their way to a healthy investment mix given their stage of life?” Benz wrote. “A thousand times yes.”