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Target-date fund basics

Target-date funds have been around for a number of years. Generally, they are tickered mutual funds that target the year you want to retire. They are usually offered by fund families, and most are funds of funds offered by that mutual fund family. Fidelity, Vanguard, T. Rowe Price, American Funds and many other fund families offer them.

Most target date fund menus come in five-year increments — for example, 2030, 2035, 2040 and so on. They offer professional management in terms of their asset allocation, rebalancing and glide path into retirement.

The glide path is a central concept of target date funds. This refers to the gradual reduction of the equity allocation of the fund as you get closer to the target date. At some point, the allocation levels off and remains constant. This will vary by fund provider. For some the glide path goes “to” retirement; for others, it is “through” retirement. Even in the latter case, the target age when the glide path levels off can vary widely between fund families.

Since the passage of the Pension Protection Act of 2006, many retirement plan sponsors have used target date funds as the Qualified Default Investment Alternative, or QDIA, to qualify for safe-harbor protection. The QDIA refers to the option used for plan participants who don’t make their own investment choice. Assets in target-date funds have grown considerably since the passage of the act.

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Robo advisor basics

Robo advisors are a relatively new financial service. There are many variations on the robo advisor theme, but in their purest form, they are automated advisors that invest your money based upon an investment algorithm. The investor generally completes a questionnaire, and the robo advisor uses this input to design and manage a portfolio tailored to the client’s needs.

The robo advisor uses the algorithm to allocate your portfolio and generally implements their recommendations via low-cost ETFs. Most are registered investment advisors.

Betterment and Wealthfront are the two largest and best known of the original fully automated robo advisors. Vanguard’s robo offering has been highly successful, though their service is more of a hybrid model and features access to a Vanguard human financial advisor. And Fidelity has recently introduced their own robo platform.

Large asset managers like BlackRock and Invesco have purchased existing robo platforms and are using them as an add-on service for financial advisors and other distribution channels.

Robo advisors vs. target date funds

A target date fund and a robo advisor can each be a viable investment solution for those investors who are not comfortable choosing and managing their own portfolio of investments. Beyond that, the two solutions are quite different.

  • One size fits all vs. flexible asset allocation – A target date fund is just like any other mutual fund in that they are one size fits all. While there is typically a range of target dates within a family of target date funds, at the end of the day, the Vanguard 2030 fund, for example, is the same for any investor who invests their money there. This is no different from any other mutual fund or ETF, target date or otherwise.
  • Mutual fund vs. advisor – Robo advisors are considered investment advisors by the SEC. Their portfolio recommendations will be tailored to your needs and your situation. Purely automated robo advisors like Betterment or Wealthfront will allocate your account among a number of ETFs based on the information you provide and their algorithm.
  • Annual fees – The expenses for target-date funds depend on the expense ratios of the underlying mutual funds used by the fund manager and whether or not there is some sort of management fee added on to the weighted average expense ratios of the underlying funds. Vanguard’s series of target-date funds have low expense ratios in the 0.17% range. Most others are higher, with some exceeding 1%. The cost of a robo advisor is their advisory fee plus the expense ratios of the underlying ETFs used in your portfolio. For example, Betterment’s advisory fee starts at 0.25%.
  • Availability – Target date funds are available in taxable accounts, but more importantly many retirement plans offer target-date funds in your 401(k). Most robo advisor services are not available in 401(k) plans but that trend is changing with the introduction of new fintech services.

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401(k) plans

Target date funds are the managed account option in many 401(k) and similar defined contribution retirement plans. Participants are typically offered the target date family chosen by their employer. For those participants who don’t make an investment election, their money may be invested in the target date fund closest to their normal retirement date under the QDIA.

Robo advice has been available to some plan participants for a number of years in the form of Financial Engines, an online investing service offered by some plan sponsors. Financial Engines is called the original robo advisor by some, and there are various levels of service offered to plan participants. At its core, Financial Engines will manage the participant’s accounts, crafting portfolios from the investment options offered by the plan.

Betterment recently launched its 401(k) offering for employers. Their all-in administrative and advisory fees start at 0.60% for plans with less than $10 million in assets and is incrementally reduced to 0.10% for plans with over $1 billion in assets. The expense ratios of the ETFs used in constructing their portfolios range from 0.10% to 0.12%.

Betterment serves as a full-plan fiduciary, and their robo solution essentially offers individually managed accounts for each plan participant.

Automated 401(k) services have sprung up. Some are robo-based; some are not.

Which option is best for you?

The answer to this question, like many in the financial planning and investing realm, is “It depends.”

With any investment option, it is important to look under the hood before investing.

Argument for a target date fund

  • Consider the quality of the underlying funds.
  • How has it done compared to its peer group of target date funds? For example, if you are considering a 2040 fund, how has this one done compared with other 2040 funds?
  • Does the glide path work for you?
  • What are the fund’s expenses?
  • If you are in or near retirement, take a look at how the 2010 version of the fund family performed in 2008. Many of the 2010 funds lost over 20% that year. These are funds that were conceivably geared to someone within a few years of retirement at that time. Make sure you would be comfortable with a loss of that magnitude in the event of another market meltdown.

Argument for a robo advisor

  • Study their investment methodology:
    • Is this a pure, totally automated robo advisor, or is it a hybrid version utilizing some level of human advice?
    • Is this robo advisor tied to a financial services provider?
  • Understand the underlying investments used to build your portfolio.
  • Make sure you understand all fees and expenses involved.

The good news is both alternatives exist, providing investors looking for a managed portfolio solution with additional options than in the past.

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Roger Wohlner Freelance Contributor

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments.

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