Robo-Advisors vs. Target-Date Funds

Robo-advisors and target-date funds are generally inexpensive ways to build a diversified portfolio for retirement or other financial goals. Robo-advisors use algorithms to manage portfolios based on risk preferences and timelines, offering flexibility and often lower fees. Target-date funds, on the other hand, provide a preset asset allocation that adjusts over time, aligning with a specific retirement or goal date. Both approaches cater to hands-off investors but differ in customization, fees and investment strategies, making it worthwhile to understand their unique features.

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What Is a Robo-Advisor?

A robo-advisor is a digital platform that provides automated investment management services without direct human intervention. Using advanced algorithms, these platforms create and manage a diversified portfolio tailored to an investor’s goals, risk tolerance and timeline. Investors typically begin by answering a series of questions to establish their financial profile, which the robo-advisor uses to recommend a suitable asset allocation.

Robo-advisors often include features such as automatic portfolio rebalancing, tax-loss harvesting and retirement planning tools, making them appealing for individuals seeking a low-cost, hands-off approach to investing.

Many platforms also offer tiered services, with some providing access to human financial advisors for more personalized advice. Robo-advisors are accessible through user-friendly apps or websites, making them a convenient choice for tech-savvy investors or those just starting their financial journey. Their scalability and affordability have made them a significant disruptor in the financial advisory industry.

Pros and Cons of Robo-Advisors

Robo-advisors offer a variety of benefits, making them an attractive choice for many investors, but they also come with limitations that may not suit everyone’s financial goals. Below is a breakdown of the advantages and disadvantages to help you weigh their value:

Benefits

• Diversification: Portfolios typically consist of exchange-traded funds (ETFs) containing hundreds of securities, ensuring automatic diversification.
• Index performance: Often mirror the performance of primary stock indexes, like the S&P 500, which outperforms many actively managed funds.
• Low fees: Generally lower fees compared to other investment services, ranging from 0.25% to 0.5% annually.
• Tax-loss harvesting: Offer tax-loss harvesting for taxable accounts, potentially offsetting investment losses.
• Low minimums: Low or no minimums to open an account, allowing investors to start with as little as $1.
• Account variety: Provide accounts for various goals, such as education or travel, in addition to retirement.

Drawbacks

• Limited customization: Portfolios are primarily algorithm-driven, leaving little room for personalized investment strategies.
• No human interaction: If your robo-advisor does not offer access to a dedicated financial advisor, that may be a concern for those who need tailored guidance or complex financial planning.
• Variable fees: Fees vary by provider and can reduce your gains if you don’t review the terms carefully.
• Market limits: Passively managed funds tracking stock indexes cannot beat the market, potentially capping returns.
• Bank restrictions: Some robo-advisors tied to banks may require you to open additional accounts or deposit money with the institution.

What Are Target Date Funds?

A target-date fund is an investment vehicle, often structured as a mutual fund or ETF, that adjusts its asset allocation over time to align with an investor’s anticipated retirement date.

The fund’s name typically reflects this target year, and its strategy evolves to become more conservative as the date approaches. These funds follow a glide path, a predetermined formula that dictates how the mix of investments shifts over time. In the initial years, the emphasis is on maximizing returns by taking on more risk. As the target date draws closer, the fund aims to reduce volatility and safeguard accumulated wealth.

Commonly included in workplace retirement plans like 401(k)s, target-date funds offer a convenient option for hands-off investors, though they may not fully align with every individual’s financial needs or risk preferences.

Pros and Cons of Target-Date Funds

Target-date funds offer a straightforward way to invest for retirement, automatically adjusting their asset allocation as the target date approaches. While these funds are convenient and designed to reduce risk over time, they also come with potential drawbacks that may not suit every investor. Below is a breakdown of the advantages and disadvantages:

Benefits

• Lower fees: Target-date funds generally have lower expense ratios compared to other mutual funds. The median expense ratio of target-date mutual funds in 2023 was 0.59%, while equity mutual funds had a median expense ratio of 1.01%, according to the Investment Company Institute.
• Ease of use: Once you provide your age or target retirement date, the fund requires no further action, reducing the complexity of investing.
• Built-in diversification: These funds typically include a mix of stocks, bonds, and other asset classes, providing diversification within a single investment.
• Risk reduction: The fund automatically shifts to lower-risk assets over time, helping protect gains from market fluctuations.
• Widely available: Offered in most 401(k) plans and IRAs, they are easy to access for retirement savers.
• Active management potential: Actively managed TDFs may outperform the market, offering the possibility of higher returns.

Drawbacks

• Potential for underperformance: Actively managed target-date funds may fail to outperform their benchmarks, leading to disappointing returns relative to their fees.
• Variable fees: Some TDFs charge higher fees, which can diminish your overall returns.
• Lack of personalization: The only customization is based on your age – investors of the same age receive identical allocations, regardless of unique financial circumstances.
• Active fund risks: Passively managed funds and market indexes often outperform actively managed funds, potentially making higher fees counterproductive.
• Minimums: Initial investment requirements can be $1,000 or more, which may be a barrier for some investors.

Robo-Advisors vs. Target-Date Funds: Key Differences

Robo-advisors and TDFs are aligned in many respects, but the distinctions can make one a wiser choice based on your financial situation. Here’s what to think about when comparing these two options:

Customization

Robo-advisors offer a higher level of customization compared to target-date funds. They consider factors like risk tolerance, financial goals, and timelines, allowing investors to tailor their portfolios. In contrast, target-date funds allocate assets based primarily on the investor’s age or target retirement year, with limited flexibility for individual preferences.

Asset Allocations

Certain target-date funds offer a further degree of diversification through holdings in other assets, such as commodities and real estate. However, many companies offer target-date funds that prioritize in-house mutual funds, which can limit the choices of the professional overseeing your account.

Active vs. Passive Management

Robo-advisors offer passively managed funds, which follow the stock market’s trajectory instead of trying to surpass it. This approach drives down costs and offers somewhat more reliable returns (of course, there are no guarantees in investing). On the other hand, target-date funds employ financial professionals who try to find opportunities in the market to boost your gains. As a result, you could find a TDF with low fees and higher potential gains. However, beating the market is challenging, to say the least.

Expense Ratios

Costs between the two are challenging to gauge overall, and the specific companies you’re considering will give you a better idea of how much each will cost you. Robo-advisor fees typically range between 0.25% and 0.50%. While ICI data shows the median expense ratio for TDFs to be approximately 0.60%, Vanguard says the industry average is 0.44%.

Minimums

On average, robo-advisors have low or no minimums, allowing more people to start investing for retirement or other financial goals. Target-date funds often have higher minimum requirements, but this isn’t always the case.

Bottom Line

Robo-advisors and TDFs offer investors diversified, often low-fee funds that can provide solid gains. Investors who want more personalization, customization, and passive management may prefer a robo-advisor. Conversely, suppose you want to devote less thought to your portfolio. In that case, target-date funds require minimal personal information, and financial professionals will invest your money based on how near you are to retirement. Of course, fees, minimums, and other details vary by company. So, like with every crucial financial choice, research is essential.

Retirement Planning Tips

• A financial advisor can help you create a financial plan for your needs and goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Robo-advisors and TDFs may be less expensive than other investment choices, but they aren’t free. Instead of paying for an investment service, you could start your own portfolio. It may sound intimidating, but if you have the time to learn, you can become proficient in the basics of trading, such as asset allocation.
• Planning for retirement is a challenge, and losing track of the details can be easy. For example, Social Security likely won’t afford you enough money to fund your retirement, but it can help quite a bit. In turn, it’s important to include your projected Social Security earnings in your retirement savings projections. To get a glimpse of what you can expect, visit the SmartAsset Social Security calculator.

Photo credit: iStock.com/whyframestudio, iStock.com/FatCamera, iStock.com/JLco – Julia Amaral