Target-date funds typically are promoted as an easy way for investors to ensure they have a suitable portfolio. But that doesn't mean they're bulletproof, financial advisers warn.
They say investors are making some avoidable mistakes when it comes to buying target-date funds, which typically include a mix of stocks and bonds and become more conservative as a "target" retirement year approaches.
For example, some people are picking target-date funds that don't sync up with their risk tolerance, while others are buying too many of them or ignoring the funds' sometimes high fees. As a result, some investors are taking on more risk than they bargained for or overpaying for their investment, advisers say.
Here are some common errors and how to avoid them:
The Mistake: Picking a target-date fund that doesn't match your risk tolerance
Just because a fund has an investor's expected year of retirement in its name doesn't mean the mix of holdings and the fund's risk level are right for that investor.
It is critical that people "look under the hood" of a target-date fund to make sure they are comfortable with its level of stock exposure, says Elaine Scoggins, a Seattle-based financial adviser. Investors caught unintentionally in an aggressive fund might "panic and go to cash" when the market gyrates, potentially locking in painful losses, Ms. Scoggins says.
For those limited to one company's lineup of target-date funds say, in a 401(k) retirement plan switching to a fund designed for people retiring sooner is one way to cut back on risk.
The Mistake: Assuming all target-date funds are created equal
The allocations inside target-date funds can vary significantly from fund company to fund company, even for funds geared toward the same retirement date. Those starting new jobs should pay particular attention to this point, says Alan Moore, a Rapid City, S.D., financial adviser. He says he has seen clients select a certain target-date fund in their new employer's retirement plan because they assumed it was nearly identical to the fund they owned in their former employer's 401(k) plan.
"When someone switches employers, they should really sit down and educate themselves on their [new] company's investment options," says Mr. Moore.
The Mistake: Buying too many target-date funds
There is rarely a reason to own multiple target-date funds, advisers say.
Ben Birken, a Chapel Hill, N.C., financial planner, says he has a client who invested in two different target-date funds from the same major provider. That doesn't add to diversification, he says, because target-date funds from the same sponsor almost always invest in the same underlying funds.
Mr. Birken also advises against owning target-date funds from different fund families, partly because it complicates investors' ability to get a true read on the level of risk in their portfolios. Instead, he may advise clients to choose one target-date fund that is the closest match to their ideal asset allocation.
When people invest in several target-date funds simultaneously it usually means they don't know when they are going to retire, says Kevin Crain, head of institutional client relationships at the retirement-services business of Bank of America Corp.'s Bank of America Merrill Lynch unit. He says he often sees this among younger investors for whom retirement is a long way off. Even for them, he says it makes more sense to pick one fund, then switch to another later on if their retirement picture changes.
The Mistake: Ignoring target-date fund expenses
Some target-date funds have high expenses that eat into returns, says Christopher Jones, chief investment officer at Financial Engines Inc., an advisory firm based in Palo Alto, Calif. Those considering investing in a target-date fund within a 401(k) should compare the expenses of the target-date option to the other funds available, he says.
Anything more than 1% in annual expenses is pricey, Mr. Jones says, meaning that investors might do better combining U.S.-stock, international-stock and bond funds on their own instead.
"If you can create the same asset-class exposures as a target-date fund, but save [half a percentage point] in annual expenses, you are likely better off," he says. Indeed, saving that much over 20 years "means about 10% higher wealth at the end of the period," says Mr. Jones.