Do Target-Date Funds perform better in your Corporate 401(k) Retirement Plan?

Chris Reddick |
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What are Target-Date Funds?

Target-date funds are essentially one mutual fund you can save for your 401(k) retirement plan. You would pick your target retirement date, and a fund such as 2045 would correspond to that date. More than half of all 401(k) participants have at least some money in target-date funds. Target date funds are often found in most corporate retirement plans.

What is unique about target-date funds is that you can set it and forget it. Well theoretically! The fund has a glide path that moves from mostly stocks to mostly bonds as you approach your retirement age. The idea is that you move from riskier assets of stocks as you get closer to retirement and into safer bonds in your portfolio. Target-date funds do the heavy lifting of investing in that they buy the underlying funds and combine them into one fund. So if you did your own target-date fund, you would buy a percentage of US stocks, non-US stocks, and the same for bonds. You can see why target-date funds are particularly appealing, as all of the rebalancings do not have to occur as the fund does it automatically.

Sounds very simple and appealing to novice investors. In fact, corporate America has fully embraced this as a default option for many retirement plans. The employee is essentially auto-enrolled into a target-date fund in many corporate plans. Are all target-date funds the same in terms of performance?

What does the research say?

But being a professor, I was curious, what does the academic research show us about the performance of these target-date funds? I did my research, so you would not have to read boring academic papers, and came up with the following 3 conclusions:

1. Lower fee target-date funds perform better than higher fee funds. Essentially, index target-date funds performance (such as Vanguard) is superior to actively managed target-date funds. The research shows that higher-priced actively managed funds had a lower performance. In fact, the adoption of low-cost target-date funds may enhance retirement wealth by as much as 50 percent over a 30-year period.1


2. If you don’t have available more passive index funds, actively managed funds performed just as well as buying the underlying mutual funds. This research shows that with a target-date fund, even if it is actively managed, which may be the only option in your retirement plan, you are doing just as well as buying the underlying funds it invests in.2


3. For younger investors, more actively managed target-date funds performed worse than funds for those closer to retirement. For instance, 2045 target funds underperformed by 35%. This is an interesting finding showing that performance is much worse in actively managed funds when there is a long way to retirement. This research does conclude that the results are better for passively managed funds.3

My bottom line

Target date funds, in my opinion, are still a good choice for saving for retirement, even if they are actively managed. They provide much-needed diversification, especially for novice investors who might have difficulty coming up with 5 to 8 mutual funds to create a diversified portfolio.

But other options, I believe are better, are called fund of funds. Essentially, with these funds, you would first do a risk profile survey. Vanguard offers a retirement risk tolerance survey. You would then pick a fund of fund from this survey, either growth, balanced, or conservative.

This would enable you to determine your allocation of stocks and bonds. For example, when approaching retirement, might have a balanced fund with 60% stocks and 40% bonds. Or someone starting their corporate career might have a risk tolerance for a growth fund of 10-20% bonds and remainder stocks. These funds can correct some of the issues with the glide path that the research shows with target-date funds.

I think the invention of target-date funds has really improved retirement investing, especially for corporate professions. Be sure to talk to a financial planner to evaluate your risk tolerance and see your best retirement saving options.

1. https://repository.upenn.edu/prc_papers/573/
2. https://crr.bc.edu/briefs/target-date-funds-whats-under-the-hood/
3. https://siepr.stanford.edu/sites/default/files/publications/20-044.pdf

 

This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on to avoid any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.

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