Target-date funds have been on a tear, and it doesn't look like they'll lose popularity anytime soon.
More than $1.1 trillion in assets is now invested in them, according to BrightScope, a researcher that ranks 401(k) plans. That's a 280 percent increase in five years, and BrightScope predicts that $2 trillion will be invested in such funds by 2020.
Target-date funds got a major boost in 2006 with the Pension Protection Act of 2006, which allowed employers to default employees into them if they didn't elect another investment option. Previously, those employees would have been directed toward money market or stable value funds, where those contributors had no chance of growth.
Eighty-eight percent of 401(k) plans now offer a target-date option among their investment choices, and 64 percent of participants had a position in them at the end of 2014, according to Vanguard Group, the largest provider of target-date funds.
The appeal to investors is obvious, said Brooks Herman, BrightScope's head of research. "By and large—while they're not a magic bullet—they do a good job of helping employees do the right thing," he said.
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Target-date funds take a lot of the guesswork out of investing for retirement. Just pick your retirement date and the fund does the rest. The offerings are more aggressive on equities when retirement is still a long way off, and they grow gradually more conservative along a glide path.
Some funds are managed only "to" retirement, and their asset allocations are the most conservative at their target date. Others are managed "through" retirement so that they continue to maintain an asset allocation of stocks and bonds even when investors are already retired.
Many financial experts believe that while target-date funds are an improvement from no-growth money market funds, where many retirement assets languished due to inaction, investors might be able to do better on their own. Here's a look at some pros and cons of target-date funds.
- Instant diversification. One of the hardest investment decisions that any investor can make is asset allocation, or the precise proportion of stocks, bonds and other asset classes that will provide the appropriate returns. In fact, academic research suggests that asset allocation, not investment savvy, is the primary driver of portfolio's performance.
Target-date funds relieve you of having to make this decision.
- Great for newbies. One of the knocks against the modern retirement system is that it places too heavy a burden on individuals who may lack investment know-how. So it should come as no surprise that target-date funds are especially popular among employees with the least investment knowledge. In their February 2015 study, "Investor Sophistication and Target-Date Fund Investing," Michael Guillemette, Terrance Kieron Martin Jr. and Philip Gibson report that target-date funds are used the most by less-sophisticated 401(k) plan participants.
"Those who scored lower on [the] financial sophistication scale were 22 percent more likely to invest in target-date funds," said Guillemette, a certified financial planner and an assistant professor in the Department of Personal Financial Planning at the University of Missouri. "That's a good thing."
- Fees are coming down. According to BrightScope, fees on target-date funds continue to fall. The lowest-cost share class for each target-date series was 65 basis points at the end of 2014, down from 72 basis points just three years earlier. "Like most things in the retail marketplace, fees are coming down," said Herman at Brightscope.
- Own fund family. Most fund families use funds only from their own lineups. In other words, if you're investing in the Fidelity Freedom series, don't expect to find funds from T. Rowe Price or American Funds in the mix, and vice versa. "To think that any fund family would be the best option across the board is unrealistic," said Justin Goldstein, a director at Bronfman E.L. Rothschild, a wealth management firm that consults with 401(k) plans and provides employee education.
- Few fund choices. Some target-date funds have a slew of underlying funds; for example, the Harbor Target Retirement 2040 has 14. But most have just a handful of funds that cover broad asset classes. Conspicuously absent are any alternative investments. "In your 20s and 30s, you probably don't need to bother with alternatives, but as people get closer to retirement, alternatives can smooth out the volatilities," said financial advisor David Crossman, a senior portfolio manager at Bedel Financial Consulting.
- Treats age and risk tolerance the same. Target-date funds treat identically every investor planning to retire in a particular year. The funds equate time horizon with risk tolerance. While younger people have more risk tolerance in theory, in practice that isn't always the case. Some young investors are gun-shy about stocks, and some older investors are unruffled by market ups and downs. "The underlying essence of investing is extremely personal, but target-date funds do not account for that," said Katrina Lamb, head of investment strategy and research with MV Financial.
The bottom line? A target-date fund is a solid choice in many cases.
If you're not inclined to investigate all your investment options and come up with an optimal portfolio—and then monitor it on an ongoing basis—then a target-date fund is probably the way to go. What's more, a target-date fund may be the best choice available in your plan.
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But for investors willing to take a more active approach, a target-date fund may be too limiting. Decide your ideal asset allocation and then implement it with the fund choices in your plan or get a financial advisor to help you.
But keep in mind, then, that you'll need to do some of the heavy lifting of a target-date fund yourself. As you move closer to retirement, you'll need to revisit your asset allocation and make adjustments along your own glide path.
—By Ilana Polyak, special to CNBC.com