Target-Date Retirement Funds: Pros and Cons

Target-date retirement funds (TDFs) are mutual funds or ETFs that automatically adjust your allocation, as you get closer to retirement, away from mostly stocks toward a more conservative blend of stocks and bonds. Someone who will reach age 65 around 2050 (a person currently about 36 years old) would invest in a fund with that “target date,” and the fund will be invested largely in stocks at present; the 2025 fund, by contrast, is designed for someone who will turn 65 in the next few years, and may contain only 50-60% stock and the rest bonds.

TDFs: Some History

These funds have been around for almost three decades, but they took off dramatically in 2007 after the Department of Labor, in implementing provisions of the Pension Protection Act of 2006, classified TDFs as a “qualified default investment alternative” for employer-funded 401k and similar plans, a classification that shields employers from some liability that might otherwise arise in the course of sponsoring a retirement plan.

TDFs have proven to be one of the great inventions of all time—ok, maybe not as high on the list as the light bulb or internal combustion engine, but definitely above the lava lamp and hula hoop. Why? Because they reduced the burden employees face in determining how to invest the money in their 401k (or 403b or IRA). Once upon a time, employees were covered by company pensions, something now even rarer than a bald eagle or monarch butterfly. With the shift from pensions (defined benefit plans) to 401ks etc. (defined contribution plans), the burden of saving for retirement—including the choice of how to invest 401k dollars contributed by their employer and often themselves—now fell upon the employee. This proved to be overwhelming and confusing for so many employees, most of whom have no investment expertise. TDFs partly help ease that burden, for they contain implicit investment advice: choose the TDF whose year is closest to the year you will turn 65 and you will (probably) be okay.

From a policy perspective, TDFs have been a huge success. Before the rise of TDFs, employees invested much of their and their employers’ 401k contributions in money market funds (essentially cash), which earned little return, and to the extent that they invested in stock, it was often company stock, which, in a well-diversified portfolio, should play a pretty small role. With the advent of TDFs, the diversified stock holdings in 401ks rose dramatically, and 401k balances became fatter as a result.[1] Another benefit of TDFs is that many employers automatically enroll employees in the age-appropriate fund and require employees actively to “opt out” if they don’t wish to participate. That “nudge” can be credited with getting ever greater numbers of employees to save for their retirement, something many fewer would do otherwise. 

The Trade-Off: TDFs Manage Risk but Earn Somewhat Lower Returns

The main advantage of TDFs for the individual investor (apart from the global benefits mentioned above) is that they help manage risk. The primary concern, regardless of one’s individual risk tolerance, is what is called “sequence of return risk”: how big your portfolio is at retirement will be determined by the sequence of annual returns over the course of the saving period, especially the last few years. The annual returns that have the greatest impact on the size of your portfolio are the seven immediately following retirement, with the first two years following retirement being the most crucial of all.[2] If you are unlucky enough to have your retirement coincide with a sharp market downturn, the annual level of income you will be able to draw from your 401k (or 403b or IRA) could be a lot less than you were expecting. TDFs, which taper away from stock as one nears and moves into retirement, can help mitigate this risk.

But TDFs also suffer from a serious downside: they provide lower returns than some other portfolio allocations. If you look only at average final 401k balances at retirement, TDFs generally do not perform as well as funds that maintain a 100% or 80% exposure to stock throughout the saving period. The reason is what is called the “portfolio size effect”: it is toward the end of the saving process, maybe in the 10 years just before retirement, where the portfolio is at its largest, that growth is most important; growth is less significant earlier in the saving period because there is less money to grow. For this reason, some people even advocate a reverse taper: start saving with lower exposure to stock and steadily increase to 100% stock right before retirement.[3]

So one faces a trade-off: in most years a 65-year-old retiree will have a higher balance in their account if they have invested 80% or 100% in stock throughout; but if they retire in an unlucky year, especially one characterized by a sharp market downturn in the few years right before retirement, they could have a good deal less. A recent study puts the trade-off into historical perspective, using historical returns to compare final 401k balances at retirement for retirees who had saved for 40 years, retired in one of 70 years from 1940 to 2009, and had one of three portfolios: a 100% stock portfolio throughout, an 80% stock portfolio throughout, and a TDF that started out with 90% stock and tapered over 40 years to 55% stock. It found that the 100% stock portfolio beat the TDF 91% of the time, and the 80% stock portfolio beat the TDF 79% of the time. And what about that 9% and 21% of the time, respectively, that the TDF performed better? The case of the 100% stock portfolio is illustrative: most of the time, the 100% stock portfolio was not beaten by much; but there was one notable exception, the 65-year-old retiring in 2009, after the worst year for stocks since the Great Depression. In that year, the TDF outperformed by a lot.[4] That, in a nutshell—one really terrible year out of 70—is why many people like TDFs.

But TDFs are a “one size fits all” solution to risk. They assume that everyone would choose to take a somewhat smaller final 401k balance in exchange for avoiding a one-in-70 catastrophic retirement year. TDF design also does not take into consideration other sources of income one might have in retirement, which may change the risk calculus. For example, if someone has a pension, however modest, they may be comfortable with a more aggressive allocation in their 401k. Same if they have the kind of skills that give them the option of earning income in retirement, if they need to or want to, by working part-time or on a consulting basis.

Even if the TDF concept suits your risk profile—and for many people it does—different TDF families offer rather different tapers from stocks to bonds. The TDFs out there for employees 25 years from retirement (for the typical 40-year-old) have stock allocations that range from 88% to 95%, and funds for those 20 years from retirement (for the 45-year-old) range from 84% to 90%.[5] These are not huge differences, but a TDF that has 6-7% less in stock exposure than other TDFs over a period of 40 years can result in tens of thousands of dollars less in the account at retirement time.

Navigating the Trade-Off

So what is the solution? There is no easy answer. The first thing is to have a good, detailed conversation about risk and other factors (e.g., existence of pensions, potential for post-retirement income) with a fee-only financial planner. If the TDF model suits your profile, that’s great: they are very convenient for the right investor. But you should still consider the TDF options you have available. Do they come with low fees (say, an expense ratio of 0.20% or less)? I would avoid those with expense ratios of 0.50% or higher: these are typically more actively-managed funds and studies show that they do not justify their higher costs.[6] And if you are not happy with the allocation in the TDF that is designed for your age cohort, you can always choose a different fund intended for an earlier or later retirement year: for instance, if you are around 36 years old now, instead of sticking with the default 2050 fund, you might consider the 2045 fund if you are more risk averse than average or the 2055 fund if you are comfortable with more aggressive investing. And if you have multiple TDF families to choose from (not an option with most employers, but an option for many IRAs), you could choose that 2045 fund with 88% stock rather than the one with 95% stock or vice-versa (see above).

But if you can tolerate greater than average risk, you could consider an allocation with either a fixed allocation to stock (e.g., 80% or 100%) or even a reverse glidepath, in which the allocation to stock increases as one moves closer to retirement. Or you could work with your fee-only financial planner on a customized TDF, using index funds offered by the employer as the building blocks: this could allow you define the taper that makes sense for your unique financial situation.

[1] O. Mitchell and S. Utkus. “Target Date Funds and Portfolio Choice in 401(s) Plans,” NBER Working Paper No. 26684 (2020).

[2] W. Pfau, “The Lifetime Sequence of Returns: A Retirement Planning Conundrum” SSRN No. 2544637 (2013)

[3] E.g., A. Basu and M. Drew, “Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds,” Journal of Portfolio Management 35 (2009) 61-72.

[4] W. Pfau, “Lifecycle Funds and Wealth Accumulation for Retirement: Evidence for a More Conservative Asset Allocation as Retirement Approaches,” Financial Services Review 19 (2010) 59-74

[5] J. Estrada, “Target-Date Funds, Glidepaths, and Risk Aversion,” IESE Business School Working Paper No. ART-2664-E (2020) 12.

[6] J. Shoven and D. Walton, “An Analysis of the Performance of Target Date Funds,” NBER Working Paper No. 27971 (2020) 24.