Why Target-Date Funds are Out of Date

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The following are some commonly asked questions and concerns I’ve heard from advisors about 401Ks, target-date funds and retirement.

1. Are target-date funds (TDFs) a good thing or a bad thing?

A little bit of both. They are easy for investors and reduce the burden for plan sponsors. For money managers, it increases participation and assets go up. But, there have been problems when performance has disappointed.

2. Why do you think TDFs are outdated? What needs to change?

They are facing some challenges and they must change their thinking. The investment environment is not pretty. When you look at stocks or bonds, neither looks particularly attractive today. Stocks are at an all-time high. People are nervous. With bonds, yields are low. Should interest rates rise, bonds are susceptible to losses.

People need to think about the big risks – a systemic selloff in stocks or bonds, or both. TDFs do not protect as much as they should in bear markets. We saw that during the financial crisis. The most conservative TDFs lost, on average, 31%. Aggressive funds were down more. Advisors need to think differently about their investment options. TDFs need to do something about that market risk.

3. TDFs are often the default investment option for 401K plans that we recommend. Is there anything wrong with this “set it and forget it” approach?

TDFs are designed to make it easy. The flaw is that people try to make retirement planning too easy. Spending time with participants to go beyond the “one-click” solution of choosing a TDF. The investment in a 401K plan is only part of the overall picture. Investors should consider if their TDFs are within the context of an overall financial plan. Dig deeper with your clients to educate them. Focus on getting people actively thinking about factors that go into retirement. The first step is not the last step.