Rising costs, particularly the cost of buying a house and repaying student loans, are forcing millennials to start thinking about their financial future. With a vast landscape of investment options available and with limited knowledge in the market, many millennials are turning to target-date funds (TDFs) as a set-it-and-forget-it investing method. Although TDFs are gaining popularity with millennials and company-sponsored retirement plans, it’s important to know the benefits and risks associated with them.
The Benefits
Convenience. 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.
Automation. 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.
The Risks
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.