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Target-Date Funds in Retirement Planning

Target-Date Funds in Retirement Planning

Faculty Member Wade Pfau Landscape Photo
Reshma Kapadia, Barron's
September 14, 2019

Wade Pfau, Professor of Retirement Income, met with Barron's to provide his insight on asset allocations for target-date funds. This article was originally published in Barron's.

Conventional wisdom says investors in target-date funds should pick the one closest to their projected retirement age and go all-in. But for those who want a more customized approach, it may be worth ignoring the rule of thumb and mixing a target-date fund with other options.

Target-date funds, which offer a one-stop option for those who don’t want to actively manage their retirement assets, have become the default way to save for retirement in 401(k) plans. They represent about 21% of all 401(k) plan assets, according to the latest report from BrightScope and Investment Company Institute. And a large swath of retirement savers allocate their entire balance to a target-date strategy—58% among the large-market plans T. Rowe Price provides record-keeping and retirement services for.

David Blanchett, Morningstar’s head of retirement research, believes this all-or-nothing tendency is the right approach. Investors who mix and match other investments with a target-date fund are often doing so to make their portfolio more aggressive, Blanchett finds, but his research shows they could achieve a similar outcome by just picking a target-date fund that has a later “vintage” year. For example, he says, an investor could pick a target-date fund that has a retirement date 10 years later than anticipated and would likely have a higher stock allocation.

But mixing and matching a target-date fund with other funds isn’t necessarily an investing faux pas. For starters, target-date funds are a blunt instrument for retirement savings that primarily considers age when a lot more factors should be considered to create an allocation.

Target-date funds of the same vintage can also have big differences in their holdings, such that an investor might want to supplement with other assets. “Asset allocations for target-date funds vary dramatically between different fund companies, and users may not understand that their 401(k) is offering a particularly conservative or aggressive version of a target-date fund,” says Wade Pfau, a professor of retirement income at The American College of Financial Services.

Consider the allocations between these two 2040 target-date funds: The $2.2 billion Fidelity Advisor Freedom 2040 fund (ticker: FAFFX) has 93% allocated to equities, while the $1.7 billion American Century One Choice 2040 (ARDVX) had 69% in equities. Because of those different allocations, the recent performance of the two funds diverged, says Todd Rosenbluth, head of ETF and mutual-fund research at CFRA.

Digging into target-date holdings will also often turn up differences in global and domestic exposure as well as the types of bonds held.

Of course, many investors using target-date funds within their 401(k)s can’t shop around and are usually stuck with the one offered by their employers. But understanding the risks and allocation of the offering can help them decide how to complement that fund in their 401(k) portfolio by possibly mixing it with other options for a more customized portfolio.

Take bond exposure. Only 14% of plans offered high-yield or global fixed-income funds and just 2% offered emerging-market debt funds, according to a T. Rowe Price report on the 401(k) plans it services. So if an investor wants to create a more nuanced fixed-income allocation but has limited options in his 401(k) plan, he could use a target-date fund not tied to his age but rather one geared toward near-retirees to build the bond exposure, says Joe Martel, a portfolio specialist on T. Rowe Price’s multiasset team. T. Rowe’s Retirement 2020 fund, for example, has eight different underlying fixed-income portfolios, including global fixed income, absolute fixed income, high-yield debt and emerging-markets debt.

Another option is for investors to use their target-date fund as a core holding and invest in other funds in their plan as satellite investments if they feel strongly about a particular asset class. This is the most prevalent scenario Vanguard Group sees among mix-and-match investors, with many allocating more than half to the target-date fund, says Scott Donaldson, senior investment strategist at Vanguard.

There are advantages to keeping target-date funds in the mix, like cost. In small to midsize plans with assets under $100 million, according to the Brightscope-ICI report, the average expense ratio for a target-date fund is two to five cents cheaper than domestic stock funds in 401(k) plans—and much cheaper than international stock funds, for example.

And investors who eschew target-date funds also have to grapple with the psychological aspects of market performance: “You could create your own target-date-fund-like allocation with similar building blocks in the plan, but since it is not bundled, the net asset values and price of the different blocks may be more volatile,” Donaldson adds. “If participants can see it in moving parts on a weekly basis, they may be more apt to chase performance” rather than riding the markets’ ups and downs.

The stability target-date funds bring to a portion of a portfolio can act as an anchor. In the end, however, it comes down to preferences of how active an investor wants to be and their investment aims. But if done right, mixing and matching shouldn’t be relegated to the investing faux pas list.

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