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The pros, cons of using target-date funds in 401(k) plans

Target-date funds offer a simple way for investors to allocate investment dollars for the long run, but as with everything, the devil is in the details. Several financial advisors offered their thoughts to CNBC on the pros and cons of using these types of funds within 401(k) plans.

Pros

"Target-date funds are very easy to deal with for automatic enrollment for the employer, helping them serve their fiduciary role," said James Gambaccini, certified financial planner and managing partner of Acorn Financial Services. In addition, they "can offer a very diverse portfolio in as few trades as possible for the employee," he said.

Archers taking aim at target
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Target-date funds are an excellent option for amateur investors to set their portfolios on autopilot, because they are typically automatically rebalanced and reallocated as target retirement ages are reached, according to Sterling D. Neblett, CFP, founding partner of Centurion Wealth Management.

"I would strongly argue that the target-date fund would do a much better job aligning with the investor's goals than the investor would do on their own," he said.

Cons

Two negative aspects, Neblett said, are that most target-date funds are funds from one company, which may not have the top managers in each of the asset classes. The other concern is that investors give up control on where to overweight and underweight their investments.

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"Be aware of the heavy stock allocations in the early years of the glide path," said Patrick Stark, CFP, director of financial planning at RS Crum. "In a way, target-date funds are an arms race, where the heavier stock percentages win out in bull markets.

"So anyone investing in these funds, especially the farther-out years, needs to be prepared for a lot of volatility."

Watch out for fee padding, he added.

"The gold standard is Vanguard, whose fees range from 0.14 percent to 0.16 percent," Stark said. "One of my clients had [the company] as a target-date choice in his plan, but the expense ratio was quadruple what Vanguard actually charges."

Also considering cost, Gambaccini of Acorn Financial Services said that for clients with more than $250,000 in assets, using a target-date fund is more expensive than building a custom allocation based on specific client goals. He gave two reasons: the extra layer of management needed to rebalance the fund of funds, and that target-date funds are less effective than a personalized approach.

"Often with target-date funds, the fund managers are making an assumption that the 401(k) is the entirety of the employee's retirement funds, when in fact the client may have other IRAs or spousal retirement accounts," he said. "In doing so, both the assessed risk and portfolio allocation do not meet the client's needs or retirement goals."

Target-date funds can vary greatly, according to Ryan Fuchs, CFP at Ifrah Financial Services.

Aiming at target-date funds

Helpful questions for choosing an appropriate target-date fund, whether a 401(k) plan sponsor or an individual investor:

  1. Philosophy – Do you want actively managed (higher-cost) or passively managed (lower-cost) target-date funds?
  2. Glide path – Is the amount of risk (equity percentage) of the glide path appropriate for the demographics (investors) of the plan?
  3. To or through? – Is the glide path at its most conservative point at retirement date (a "to" fund)? Or does it become more conservative past the retirement date (a "through" fund)? Is the risk exposure appropriate for the client?
  4. Low costs – Are the funds in the lowest quartile of the expense universe within their group?
  5. Sticking with leaders – Is the target-date series in danger of being shuttered? If a lesser-known fund company, is it chasing gimmicky or trendy investment strategies to try to garner attention in a space dominated by the leaders?
  6. Ongoing monitoring – If you're acting as fiduciary, is your initial selection and ongoing monitoring criteria tied to an Investment Policy Statement and an ongoing prudent process?

Source: Steve M. Burkett, CFP at Palisade Investments


"A particular target date, even if around the time you plan to retire, may not be as conservative or aggressive as you desire," he said. "Make sure that you're comparing apple to apples because one company's 2030 target date may not have the same [or even similar] asset allocation to another company's [offering]."

Fuchs cautioned that target-date funds may engender a false sense of security. "These funds can cause people to pay less attention to their portfolio because they think everything will be taken care of for them," he said. "But they still need to be sure to review their portfolios and accounts from time to time to make sure things are performing properly and that the allocation stays on their preferred target.

"Target-date funds try to be a one-size-fits-all solution to investing, but not everyone's situation is the same."

— By Deborah Nason, special to CNBC.com