The Pros and Cons of Target-Date Funds

By Mark Cussen Markets Fool.com

Target-date funds have become popular options for many investors who want their portfolios to adjust over time to match their changing needs. These funds allow investors to take a hands-off approach to their portfolio management and can provide peace of mind to investors who want to own a relatively conservative portfolio when they retire.

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Also known as life-cycle funds, target-date funds are mutual funds composed of a group of other mutual funds. They are typically designed to invest fairly aggressively when they are first released, and then gradually reallocate to become more conservatively invested over time. When the actual target date is reached, the fund will usually be invested mostly in bonds and other safe offerings, with a small amount of the portfolio still allocated to stocks in order to provide a hedge against inflation.

As an example, the target-date fund that is offered inside the Thrift Savings Plan for federal employees had about three-quarters of its assets invested between three stock funds when it was issued, with the remainder split between two bond funds. The portfolio managers at Blackrock Capital will reallocate a tiny portion of the money in those stock funds into the bond funds every 90 days until the fund hits its target date in 2040. At that time, the fund will have three-quarters of its money split between the two bond funds, with the remainder divided between the three stock funds to provide a hedge against inflation.

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If you don't feel up to the task of managing your retirement savings, then a target-date fund can take a lot of the work off your hands. But these funds are not without their drawbacks. Here's a breakdown of the pros and cons that come with these funds.

Advantages of target-date funds

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As mentioned previously, target-date funds allow investors to take a "set it and forget it" approach to their investing. Investors and retirement plan participants who are not financially sophisticated can use these funds to meet their investment objectives as they change over time. They also provide you with a greater level of diversification, as your money will be spread out over several mutual funds.

Drawbacks of target-date funds

Despite their seeming simplicity, target-date funds also pose some disadvantages to investors. One of these is their relative tax-inefficiency. Those who purchase these funds outside of an IRA or qualified plan may realize capital gains (and thus trigger capital-gains taxes) on a regular basis as shares of the funds that have performed well in the target-date portfolio are sold off and moved into shares of funds that have not performed so well. For this reason, target-date funds are commonly used inside tax-deferred retirement plans in order to avoid this problem.

The glide path (the transition from an aggressive portfolio to a conservative one) can also vary substantially from one target-date fund to another, which means some funds are exposed to a great deal more risk than others by the time their target date arrives. Some will still have 70% of their portfolios invested in stocks at the target date, while other funds will only have 30% of their assets still held in equity funds.If you're considering using a target-date fund, first take a close look at the allocation of a target-date fund from the same fund family that is about to mature or has already matured. This can help you to determine whether the target-date fund you're looking at will match your risk tolerance at the target date.

Target-date funds also often charge higher fees than other types of mutual funds, because these funds will pass through the fees charged by the underlying fund options that comprise the fund as well as its own management fees. Morningstar reports that the average target-date fund's annual fee is over 1%. This can substantially reduce the return posted by the fund over time. Investors who bypass target-date funds and invest directly in the underlying funds can avoid some of these fees, although they will be responsible for manually reallocating the funds to match the glide path of the target-date fund over time.

Target-date funds can provide hands-off investment management for many investors, but buyers should do their homework on the particular fund that they choose before investing. Although these funds can effectively put a retirement portfolio on autopilot, they often come with high fees that drag down their returns over time.

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