There’s a wrong way to use target-date funds

The benefits of using the increasingly popular target-date funds as turnkey solutions in retirement plans are sometimes diluted by retirement savers who pair the prepackaged products with other funds.

“When it comes to target-date funds, it should be an all-or-none situation,” said David Blanchett, head of retirement research at Morningstar.

“It’s very rare where it would make sense to combine something else with a target-date fund,” Mr. Blanchett added. “It destroys the potential value of the product, which is a professionally managed solution.”

In a report released this week, Mr. Blanchett estimates that between 10% and 25% of the 100 million participants in company-sponsored retirement plans are guilty of mixing TDFs with other funds.

And most of the time, he said, those combinations involve adding equity exposure, which increases the overall risk of their portfolio.

Of the 656,000 company-sponsored retirement plans in this country, 75% have a default option for savers who don’t select their own option. Of those plans, 85% default to a target-date fund that is managed to become increasingly conservative as it reaches the fund’s maturity date, which is the participants’ retirement date.

TDFs are 25 times more popular as a default option than the next most-utilized default, so it’s not surprising that TDF assets have grown almost tenfold over the past 10 years, to $1.7 trillion.

“The baseline argument should be that target-date funds are all or none, because that’s what they were designed for,” said Daniel Galli, owner of Daniel J. Galli & Associates.

“If you’re 40 and you want to be more aggressive than a 2045 fund, use a 2060 fund,” he said, illustrating how risk can be managed using TDFs.

Read more: TDFs come with certain risks 

Mr. Galli said he occasionally sees investors mixing TDFs with other funds “because they don’t understand the concept; they think it’s just another fund.”

Another reason, he believes investors are prone to mix TDFs with other funds is that advisers and asset managers are constantly preaching the benefits of diversification. “Everyone is also told not to put all your eggs in one basket, and sometimes it doesn’t seem quite right to put everything in one fund,” Mr. Galli said.

But even if it might seem counterintuitive, TDFs are designed to be the only fund you need, said Sean Williams, wealth adviser at Sojourn Wealth Advisory.

“For the uninitiated, or for someone not working with an adviser, I’d rather there be a target-date fund option,” he said. “But, as a planner, I’d rather walk clients through their individual risk tolerances based on something other than just a date.”

While financial planners generally support the “all or none” advice when it comes to TDFs, there are a few exceptions to the rule.

“Target-date funds are great for investors who don’t have the time or are not investment-savvy, but sometimes you can also use a target-date fund as a portfolio foundation and then add some other specific investments around it,” said Peter Hoglund, vice president of life planning at AEPG Wealth Strategies.

“I wouldn’t mix two target-date funds together; there’s no reason to do that,” Mr. Hoglund said. “But as a tactical strategy, I think of the target-date fund as the rock and I will slot in a couple of other funds around it, if I want to add some emerging markets exposure, for example.”

Darin Shebesta, a wealth adviser at Jackson/Roskelley Wealth Advisors, has gotten even more creative when it comes to TDFs.

Because he doesn’t always like the limited bond fund options in some company-sponsored plans, Mr. Shebesta said he will often use a short-dated TDF, which will be made up mostly of bond funds, for a client’s fixed-income allocation.

“I have been disappointed with some of these big employers that don’t have a lot of bond options,” he said. “The shorter-dated target-date funds can be a nice way to diversify your fixed-income exposure.”