If you are a young professional just beginning to save for retirement, you are probably wondering about the best way to do it. If you have not yet come across target date funds, you will eventually. They are one of the most popular retirement investment vehicles. Morningstar reported in May of 2020 that target date strategies held $2.3 trillion at the end of 2019.
Despite their widespread use, target date funds (TDFs) are not without their pitfalls. We will explore TDFs and consider both their advantages and their disadvantages. While you may find them in your employer’s retirement plan, they may not be right for you.
What is a Target Date Fund?
A target date fund is a fund offered by an investment company (i.e. mutual fund) that has an asset allocation (i.e. mix of asset classes like stocks and bonds) that becomes increasingly conservative over time. They are also called “life-cycle” or “age-based” funds.
Think of the fund on a glide path. The start of the path is today and the end of the path is your retirement age. So, if you were born in 1990 and you plan to retire at age 60, then your target date is 2050 and you would invest in a “2050” fund. The longer/shorter the glide path, the more aggressive/conservative the fund will be.
A TDF generally contains other funds. These sub funds represent various asset classes the manager wishes to include in the fund. A TDF may include, for example, funds for US stocks, international stocks, US bonds and international bonds. The mix (i.e. percent) of each of the funds will change as the fund glides toward its target. Specifically, it will contain less stocks (which are aggressive) and more bonds (which are conservative) over the life of the fund.
What happens when you reach the target date? A “through” TDF will have an asset allocation that continues to become increasingly conservative. A “to” TDF will maintain a fixed asset allocation once the target is reached. Sometimes these funds “convert” to other singular funds when then they reach their terminus.
Why invest in a Target Date Fund?
TDFs are attractive, because they are professionally managed and they require no decision making by the investor other than selecting the proper fund. They are highly diversified. They are simple to understand. They are automatically rebalanced and re-allocated over time. They are often referred to “set-it-and-forget-it” or “auto-pilot” funds.
Investors often underperform the market, because they make poor investment decisions. They pick the wrong funds. They try to time the market. They change funds. Investing in a TDF makes it impossible to make these mistakes.
How to select a Target Date Fund
If you are investing in your employer’s retirement plan (e.g. 401(k) or 403(b)), you will be limited to the funds in the plan. You would generally (there are exceptions) select the fund that corresponds with your retirement date.
If, however, you are considering investing in a TDF within your IRA or Roth IRA or brokerage account, you will have more options. Vanguard is the largest TDF provider with a market share of 36.5%. Fidelity (19.4%) and T. Rowe Price (13.1%) are also significant players in the TDF arena.
You should consider the strategy, asset allocation and glide path of the funds that might be appropriate for you. If you are considering actively managed TDFs (vs passive funds), you should evaluate the performance of the funds relative to an objective (blended) benchmark. You should also look at the expense ratios of the funds and gravitate to the less expensive TDFs.
Want to learn more about financial planning? Contact our team at Springwater Wealth today to learn how we can help you develop a plan for your financial future.
Pitfalls of Target Date Funds
You might be thinking TDFs sound like the perfect retirement savings vehicle. But there are several significant problems with these funds.
The benefits of a TDF come at a price, unless you are discerning. Morningstar reported that the average, asset-weighted expense ratio for target date mutual funds was 0.62% in 2018. However, TDFs are not all alike.
Let’s go look at some 2050 funds. We will consider TDFs from four of the largest players in the market.
|Fund||Gross Expense Ratio||Percent in Bonds|
|Vanguard Target Retirement 2050 Fund||0.15%||8.53%|
|Fidelity Freedom 2050 Fund||0.75%||5.87%|
|T. Rowe Price Retirement 2050 Fund||0.71%||5.58%|
|BlackRock LifePath Index 2050 Fund||0.14%||1.43%|
A few things jump out at us. The Vanguard fund and the BlackRock fund are much less expensive than the other two funds. Also, the BlackRock fund is much more aggressive than the other three funds. The lesson here is that you really need to lift up the hood on TDFs and understand how they are made and what they cost. In general, TDFs are more expensive (often much more so) than basic, low cost mutual funds and exchange traded funds.
Another problem with the whole concept of TDFs is that they are a one-size-fits-all vehicle. So, in theory every person planning to retire in 2050 would use the same TDF. But we know that investors are not all alike. We can describe investors by their risk temperament, their assets, their income sources, their spending needs, their investment horizon, etc. The 2050 funds above might be very appropriate for a young professional with a high tolerance for risk and a need to accumulate a large nest egg over a long working career. However, they would be inappropriate for someone who is risk averse, who has or will inherit significant assets and, therefore, has no economic necessity to be aggressive with her investments. They might also be a poor fit for someone who reaches 2050 and still has a need to grow his investments while in retirement.
Yet another challenge with TDFs is that they do not combine well with other funds that have a more static asset allocation. The asset allocation in the TDF will be constantly along the glide path to the target date. So, if you are trying to maintain an overall asset allocation across several accounts, you will have to rebalance all of the other accounts with reference to the TDF.
Should you use a Target Date Fund?
As we have seen that all depends on your circumstances. If the asset allocation within a fund you are considering meets your needs and you are willing to pay a premium for an “all-in-one” fund, then a TDF may make sense for you. However, if you are willing to build a more complex portfolio (or hire someone to do it for you) that is customized to your situation, then you should probably avoid TDFs.