The Benefits and Risks of Target Date Funds for Millennials
One reason for the recent surge in popularity of TDFs is that they are becoming commonplace in workplace retirement funds. Almost all workplace plans offer TDFs as an option, as they can group their workforce into retirement brackets and choose similar TDFs for everyone. With many companies going this route, not only do millennials find this option the most convenient, but they may not be aware of other options, due to the prevalence of TDFs in the workplace. This makes it easy to see why they may choose TDFs outside of their workplace investment accounts as well.
Target date funds are set up based on the target retirement year, with asset allocation already predetermined. For beginner investors, this option may sound ideal as they will not have to choose which stocks and bonds to invest in, nor the percentage of each. TDFs are also set up to automatically adjust to a more conservative allocation of assets as the target date approaches.
The convenience of relying on investment managers to handle the financial details of retirement also appeals to millennials, as they may not want to focus on retirement at their current stage of life. With a target date that is 30 to 40 years away, it can be hard to invest the time into making decisions about the future. This hands-off approach makes it an attractive option for new investors who do not have the investment knowledge needed to rebalance portfolios over time.
Over-simplified and impersonal
Many millennials opt for a TDF simply because it matches their intended year for retirement… and that’s it. There is no research done to determine if the allocation is divided appropriately between stocks and bonds, based on the individual’s risk tolerance. The millennial investor is trusting the TDF portfolio manager to insure the fund becomes more conservative as the date of retirement looms closer. Opting for a fund that’s too conservative could mean they miss out on critical returns.
Target date funds focus on the average person, with average goals and average retirement needs. They do not take into account an individual’s years until retirement, any inheritance income or lifestyle changes over time. For older investors, this may not be an issue, as many of these factors have already been considered or will not affect their retirement significantly. They may also have a clearer idea of what their lifestyle will be when they retire and how much money they will need to support it. Millennials face more risks as they still need to navigate through lifestyle changes. With many years before their retirement date, they may not be able to accurately predict when they will retire.
As TDFs do not take into account each individual’s unique financial situation, every investor would still receive the same TDF, regardless of their needs. For some, this may mean that they won’t have the expected and necessary amount to sustain their lifestyle when they retire.
Inflexible with no guarantees
Although the asset allocation in TDFs are adjusted as the predetermined date approaches, these types of funds do not take into account any changes in market conditions, leading to increased risks or a loss in potential gains.
When the financial crash occurred in 2008, many investors with TDFs who were looking at retiring in two years were shocked when they discovered that their assets plummeted in value—even though they were close to their target date. Uncertain markets serve as a particular disadvantage to millennial investors, who have a longer investment horizon. With unpredictable market fluctuations, retirement plans may take a larger hit than they expected over time. TDFs are not immune to market shifts, even as the target date approaches. This means that market fluctuations will continue to affect retirement funds.
Uncertain retirement age
There is also an increasing number of millennials who don’t believe they will ever retire, but will instead undergo several mini-retirements or complete career changes altogether. Millennial investors who fall into this category could understandably not need a target date fund as there is no set date they will retire.
PLANNING FOR RETIREMENT
When looking at TDF options, it is important to note what their glide path will be. The glide path is the rate at which equity exposure is reduced as the fund reaches the target date. Even if the target date is the same, the glide path may differ dramatically, leading to a drastic difference in the amount of money in the TDF. When looking into TDF options, it’s important for investors to know their risk tolerance at different stages in life, and to find a glide path that will match that.
A target date fund does not automatically guarantee a comfortable retirement, which means that investors should be aware of the performance of the fund as the date nears. Closer to the target date, it may be worth diversifying portfolios further to help safeguard against potential losses from market shifts. Although this idea may seem far off for millennials, it is important for them to take an active role in planning and not rely exclusively on the set-it-and-forget-it mentality.
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When considering target date funds, understand the risks beyond the benefits. There are also other funds available that can be more effective and will match an individual’s risk tolerance more closely. Look at all of your options, as it is important to have a diversified portfolio to create a successful retirement strategy, especially for millennial investors.
Christopher Crawford is the Director of Advisor Relationships for the Buffalo Funds. He has 10 years of experience in the financial services industry, previously holding positions at Invesco, IMA Financial Group, and Arthur J. Gallagher. At the Buffalo Funds, Christopher works with investment consultant relations, key account management, institutional distribution and client service. His main goal is to partner with advisors to bring business building ideas and provide unparalleled customer support to their business, always striving to make it easy and reliable to work with the entire Buffalo Funds investment team. Christopher received an M.B.A. from Washington University in St. Louis and a B.S.F.A. from Southern Methodist University. He also holds licenses for the Series 7, Series 63, and Series 65.