Target Date Funds: Overrated, Underrated, or Just Right?
Target date funds (TDFs) are a popular choice in retirement plans, especially in 401k accounts. These funds are designed to adjust the asset allocation based on the investor’s retirement date. However, are they really overrated, or are they still a strong choice by default?
Background and Regulations
The concept of TDFs gained prominence with the signing of the Pension Protection Act (PPA) in 2006. This act allowed 401k plans to have an automatic enrollment feature, encouraging new employees to start saving for retirement immediately. One of the key provisions of this act was to make TDFs the default investment choice if the participant did not opt for a different selection.
Before 2006, the outcomes for employees who did not choose their own investments were quite varied. Some companies defaulted contributions to the most conservative options, which could have been disastrous for young employees. For example, a 22-year-old might have been defaulted to a short-term interest fund and worked until retirement, which would likely not result in sufficient savings. On the other hand, some companies defaulted 100% contributions to company stock, risking a significant loss in the case of a stock market downturn.
The introduction of TDFs helped mitigate these risks by providing a diversified investment strategy adjusted based on the participant’s anticipated retirement date. Over time, additional services were introduced to make the investment process smoother and more accessible to employees, including managed accounts, educational meetings with financial advisors, and preset allocations.
Usage and Effectiveness
Studies have shown that a significant number of retirement plan participants, around 30%, opt for TDFs and stay with them throughout their entire tenure in the plan. This default feature has played a crucial role in encouraging employees to save for retirement, even if they are not financially savvy or do not have the time to manage their investment portfolio.
While TDFs are not the only investment solution available, they are particularly effective as a default option. They offer a level of protection against poor investment choices while still allowing for diversification and potential growth. However, it is important to note that some participants may be better suited to managing their own investments or choosing a different investment strategy. This depends on the individual's financial knowledge, risk tolerance, and investment goals.
The Pros and Cons
Pros:
Automatic enrollment provides a clear incentive to start saving for retirement.
Diversified asset allocation simplifies the investment process for less experienced investors.
Protection against the mistakes of inexperience.
Cons:
No guarantee of optimal performance or returns.
Potential high costs associated with managed accounts and other services.
Limitations on customization and active management of specific investments.
For many retirement plans, TDFs serve as a reasonable default investment option. They provide a basic level of diversification and risk management, which can be particularly beneficial for employees who are just starting out in their careers or who are not well-versed in investment strategies.
Conclusion
In conclusion, while TDFs are not always the best solution for every individual, they offer a valuable default option in many retirement plans. They provide a good balance of simplicity, diversification, and risk management, making them an effective choice for those who may not have the time or expertise to manage their own investments.
Whether TDFs are overrated, underrated, or just okay depends on the specific circumstances. For many retirement plans, they are a solid choice that helps protect employees from themselves and encourages them to save for the future.
Bonus: Target date funds are often used in college savings plans (529 plans), and the principles discussed here apply equally to these plans as well.