Target Date Funds: Good for Employees, Not so Great for Business Owners

Key Takeaways

  • Target Date Funds (TDFs) are designed to adjust your risk exposure automatically as you get closer to retirement age.
  • TDFs are not entirely “set it and forget it.” You still need to periodically check your accounts.
  • One key drawback for business owners: TDFs do not track the multiple assets you may have outside of the company retirement plan.

If you’re a business owner, having a company 401(k) plan is a great way to recruit, retain, and reward your employees. Among the menu of investment options available to employees, TDFs are increasingly common. With the decline of pension plans, employees are becoming increasingly responsible for managing their own retirement. TDFs are attractive because they automatically risk-adjust your portfolio as you get closer to your standard retirement age.

A recent Vanguard report found that nine out of ten plan sponsors offered TDFs. Additionally, more than half (52%) of all Vanguard participants were invested in a single TDF.

As these funds become increasingly prevalent in 401(k) plans, many business owners ponder the idea of investing their own 401(k) savings into a TDF. It seems like a no-brainer on the surface, but it depends on the number of assets you have outside of your company retirement plan. If you’re like most successful business owners, chances are it’s a lot.

Offering TDFs for Employees Is a Good Move

Often employees have most, if not all their retirement savings in their employer-sponsored retirement plan. In most cases, a TDF is a great option. As discussed earlier, these funds automatically reduce the account holder’s level of portfolio risk over time as he or she moves closer to their planned retirement date. Since the investment allocation is automated, TDFs remove many of the biases that investors and fund managers have when it comes to picking individual stocks, chasing performance, and letting emotions control investment decisions.

TDFs can appear as a “set it and forget it” approach, however it’s imperative for employees to check their accounts regularly and ensure the asset allocation in the TDF matches the employee’s risk tolerance. As the fund’s risk tolerance changes, you want to be sure it still matches your own risk tolerance.

TDFs Can Be a Problem for Business Owners

Business owners and other high-net-worth individuals tend to have significant assets outside of their company’s retirement plan. A TDF doesn’t recognize these outside investments and may have an allocation that is not in line with a person’s risk tolerance. TDFs not only miss factoring in overall risk exposure, but do not take advantage of asset location strategies.

Asset location is the practice of moving your tax-inefficient bonds (which produce ordinary income) into your tax-deferred retirement accounts, while placing your more tax-efficient stock mutual funds, stock exchange-traded funds, and individual stocks (all of which produce more favorable capital gains) into your other accounts. In Quantifying Vanguard Advisor’s Alpha, Vanguard concluded that properly executed asset location may provide up to 75 basis points (0.75%) in additional annual return to the investor. Since Target Date Funds do not factor in the benefits of asset location by considering your other investment accounts, you may be missing out on greater after-tax return potential and your target risk tolerance might not match your actual exposure.

Review Allocations with a Professional

If you’re a business owner or other successful individual, always consult with your financial advisor to ensure that you are properly allocated in accordance with your risk tolerance. Make sure that all your assets, not just your 401(k) holdings, are taken into consideration when making portfolio balance decisions.

 

James Nevers, CFP® is a Senior Advisor at Soundmark Wealth Management, LLC. James works closely with physicians, business owners, Directors and Executives at Amazon, Microsoft, and Boeing, and other successful individuals to help them define their financial goals and implement an ongoing financial planning process.