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Are Target-Date Funds the Best Place for Your Money?

Brian O'Connell

Risk evaluation is a critical, continuing step in the management of any long-term investment plan, especially if you hold all your plan assets in just a few funds, or even one fund.

Enter target-date funds, which hold the promise of accurately allocating your portfolio assets to maximum advantage. (By definition, target-date funds, or TDFs, include 100 percent of an investor's plan assets in a single, diversified fund geared toward that investor's expected retirement date.)

But does that promise really hold water?

Maybe not, according to one recent study.

A March 2016 deep dive into investor usage of target-date funds by Financial Engines reveals that, contrary to conventional wisdom, investors don't have a good grip on the funds. Specifically, investors don't keep to the path they started on with allocation-centric TDF funds.

[See: 7 Tips for Finding the Best Target-Date Retirement Funds to Buy.]

This from the study:

"The use of target-date funds in defined contribution retirement plans has increased rapidly since they were approved as a qualified default investment alternative under the Pension Protection Act of 2006. This growth has been driven by plan sponsors who often default new hires into TDFs. TDFs have been used in some form by approximately 41 percent of retirement plan participants."

Yet after a closer look at the effectiveness of target-date funds shows the TDF pedigree may be losing some of its winning luster.

"Prior research by Financial Engines and Aon Hewitt revealed that the majority (62 percent) of TDF users invest only part of their plan assets into their TDF," the study report says. "The same research study found that only 57 percent of people who started out with almost all of their assets invested in TDFs were still fully invested in TDFs five years later."

This resulted in 2.11 percent lower median annual returns, net of fees, when compared to investors who held almost all of their retirement assets in TDFs, according to the study.

"The high incidence of partial-TDF usage, and the evidence that such partial-TDF users significantly underperform more appropriately diversified investors, calls into question the efficacy of relying solely on TDFs to achieve retirement security for plan participants," the study says.

Like most market strategies, the truth behind target-date funds includes myriad moving parts, specialists say.

"Target funds can be a great way to diversify and allocate funds for individuals who want to save toward retirement but have little interest in following the markets," says Jay Schurman, a wealth manager at Lincoln Financial in Alameda, California. "TDFs help individuals to not worry about the noise in the stock market that often is investors' undoing. By not reacting to what is going on daily, the investor actually gets to receive the returns that a fund will generate."

Yet negative aspects are not hard to find, Schurman says. For example, overall TDF fees -- primarily from using so many funds -- can put a drag on an investor's performance, Schurman says.

"But this really only applies to those that actively manage their portfolios," he says. "In addition, individual nonqualified investors don't reap the rewards of end-of-the-year tax-loss harvesting using target-date funds."

Nicholas Vail, a financial advisor with Integrity Wealth Advisors in Indianapolis, also falls into the good news-bad news camp when evaluating target-date funds.

[Read: What's the Best Investing Model?]

"Target-date funds are now often being used as a default option," Vail says. "But if you aren't well-versed in investing, and most aren't, it's a great place to start."

Yet target-date funds often have gaps when it comes to being well-diversified, he says.

"A sound asset allocation involves investing across many different asset classes," Vail says. "I find that most target-date funds are lacking in many different asset classes."

Also, many investors use target-date funds but fail to realize how much risk they are taking, Vail adds.

"Instead of evaluating the volatility they are exposed to, they trust the rule of thumb with TDFs," he says. "It's not uncommon for investors to be shocked when they actually see just how much risk they are taking within their target-date fund."

The "set it and forget it model" of target-date funds does have its merits -- again, primarily for more inexperienced investors. But that model may spread investors too thin when it counts most: when they need the assets on the first day of their retirement.

"Although they have substantial benefits, retirement-date funds ultimately provide too much of a cookie-cutter approach to asset allocation," says Benjamin Sullivan, a portfolio manager at Palisades Hudson Financial Group in Austin, Texas. "Not everyone retiring in a given year has the same risk tolerance, cash flow needs and time horizon. Therefore, not everyone in a cohort should have the same asset mix."

A better idea, Sullivan says, is to focus closely on a target-date strategy when you're closing in on your retirement -- not once you get there.

"The benefit of using an asset allocation customized to your specific needs increases as your portfolio gets larger and more complex, and comes to involve multiple types of accounts," he says. "As retirement approaches, along with your need to withdraw from a portfolio, it's important to question whether a [TDF] approach is still correct for your needs."

Depending on the tax consequences, it might make more sense to fully liquidate a target-date fund before retirement in order to create your own asset allocation, Sullivan says.

"Alternatively, some investors will be best served by selling a portion of [the] fund and then incorporating other investments that allow them to bring their overall portfolio in line with their specific needs," he says.

As Sullivan puts it, retirement is an "ongoing evolution" and not a moment in time.

"People's lifestyles and cash flow needs change throughout retirement, so their asset allocations should continue to change too," he says. "That's why I'd recommend [TDFs] with asset allocations that continue to adjust through retirement, rather than just up to retirement."

[See: 10 Long-Term Investing Strategies That Work.]

As always, consult your trusted investment professional before embarking on any target-date fund campaign. Just know going in that, as more data comes out on TDF's, "set it and forget it" may not be the retirement savings panacea it's cracked up to be.



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