The Trouble with Target-Date Funds

Target-date funds have quietly become the default investment choice for millions of Americans. In workplace retirement plans, they’re the path of least resistance — simple, convenient and automatic. Select the year you plan to retire, direct your contributions to the corresponding fund, and you’re done. This feels responsible and prudent, and for many savers, it’s their only investment.

But what’s popular isn’t necessarily effective. The danger of target-date funds doesn’t lie in their mere existence or use — but rather in misunderstanding their design and shortcomings.

As target-date funds absorb a growing share of 401(k) contributions, a troubling pattern emerges: Investors mistake easy for effective, and convenient for secure. The very feature that makes these funds appealing — a gradual shift from stocks to bonds — can set up millions of retirees to steadily lose their purchasing power even as they believe they’re “playing it safe.”

“By 2027, target-date funds will capture 66% of all 401(k) contributions and about 46% of total 401(k) assets,” according to Cerulli Associates. Those numbers may have shifted slightly since then, but the trend is clear: Two-thirds of all new retirement contributions are funneled into target-date funds, silently putting millions of Americans’ financial future on autopilot.

This idea sounds great: a one-size-fits-all solution to the complicated problem of investing. For many, that simplicity is the only reason they’re invested at all. This breakthrough to participation is an undeniably a good thing, drawing tens of millions of people into investing. But participation alone isn’t the goal; sustainability is. This is where target-date funds often veer off course.

Generally, target-date funds automatically become more “conservative” closer to retirement, as they shift from stocks to bonds. This logic sounds reasonable. After all, it follows common knowledge that a portfolio should shift toward fixed income later in life.

But investors often misunderstand the consequence of that shift. Upon reaching their target date, many of these funds hold more than half of their assets in bonds. That might feel safe on paper, but in practice, it exposes investors to a very real and dangerous risk: inflation. When income depends upon a fixed-income, bond-heavy portfolio, purchasing power slowly erodes against rising prices. And over a 20- or 30-year retirement, these effects can be devastating.

Over the last century, inflation in the United States has averaged about 3% annually. That means prices double roughly every 24 years; a dollar today will be capable of buying just 42 cents’ worth of goods and services three decades from now. For retirees living longer than ever, inflation isn’t a minor inconvenience but a real and underappreciated problem.

Bonds have their place — often providing stability, liquidity and predictable income. But when interest rates are low, bond returns rarely outpace inflation. Worse, when inflation accelerates, bond prices typically fall. This once “safe” investment becomes a vehicle for slow loss.

In contrast, owning businesses via equities has historically compounded at more than three times the inflation rate. And dividends have grown nearly twice as fast as the cost of living. That means dividend-focused investors not only keep pace with inflation but enjoy long-term growth.

That growth is driven by productive assets that generate real cash flow. Businesses that make toothpaste, soap, soda, electricity or broadband — the products people use every day — continue to sell regardless of economic volatility. As prices and profits rise over time, so do dividends.

Understanding that your real risk is not in market shifts but in running out of money over time allows your definition of “safe” to shift. So why do so many investors still flock to target-date funds? Human nature. These funds reduce decisions, remove friction and suggest a smooth landing into retirement.

But this short-term comfort gets traded for long-term security. Investors often misperceive risk. They equate volatility with danger and stability with safety. Yet in investing, it’s usually the other way around: Volatility is temporary, while inflation is permanent. The former tests your patience; the latter destroys your purchasing power.

This doesn’t mean everyone should abandon target-date funds entirely. For many younger savers, they’re a fine place to start. Time in the market is better than sitting on the sidelines. But at some point, investors must graduate from “autopilot” to “awareness.”

A thoughtful portfolio should balance risk and reward not just for the next five years, but for the next thirty. That means recognizing the true purpose of investing: creating an income that grows faster than inflation. Dividend-growth investing accomplishes exactly that:  providing real cash flow from real businesses. Over time, that cash flow tends to rise — often faster than prices. While not glamorous, we believe this strategy works.

Investors can’t eliminate uncertainty, predict inflation or control interest rates. But they can choose what type of risk they take: the temporary discomfort of market volatility or the permanent erosion of purchasing power. Target-date funds may streamline retirement investing, but what’s easy isn’t always wise. In a world of rising costs and longer retirements, true conservatism lies not in owning less, but in owning better. Own the kind of businesses that raise prices while growing and sharing profit with you: the shareholder.