Are Target Date Funds a Good Idea?

July 20, 2010
Image courtesy of theilr/Flickr

There’s an awkward moment in virtually every conversation I have with HR executives about retirement plan education when they ask the question they’ve been waiting all meeting to ask:

“What do you think of target funds?”

(Translation: “We have target date funds in our plan, we used to think they were a great idea, but they’ve performed terribly and employees don’t seem to understand them. Now I’m wondering if we made a big mistake.”)

Well, here’s what I think:

  1. Target date funds are a good idea, but they are not a panacea. You cannot roll them out and expect employees are automatically going to understand them and use them effectively. Nor can you expect that a pre-set allocation and rebalancing strategy will work for all your employees. Or that by selecting a 2020 target date fund, they will actually be able to retire in 2020. Sounds obvious, but the labels do tend to lull people into a false sense of security.
  2. Used correctly, target date funds can help employees allocate and rebalance their assets appropriately to achieve their retirement goals. Used incorrectly, employees can actually end up with a worse allocation by combining target date funds with a random selection of other investments.
  3. Education is more important with target date funds, not less so. Employees need to understand pros and cons of using a target date fund, they need to choose the fund whose allocation and rebalancing strategy best mimics both their risk tolerance and time horizon not just the fund with the magic date attached, and they need to understand the pitfalls of mixing target date funds with other investment options.

Bottom line, target date funds can be a good tool, but, like any tool, they need to be used and implemented the right way.

Think of it this way: A hammer is a great tool for driving a nail into a wall, but it can cause a lot of problems if you use it to kill a fly.