By Dr. James M. Dahle, WCI Founder
Target Date Funds (TDF) are also known as target retirement funds or lifecycle funds. While a similar feature is available in most 529s, when we talk about TDFs we are generally discussing funds that are designed for retirement. They generally include a year in the name of the fund and are theoretically selected by matching that date to your expected retirement date. They have a number of features:
- Fund of funds structure
- Professionally managed
- Automatically rebalanced
- Become less aggressive over time
Like any investment structure, there are pros and cons to target date funds. In the best funds, the pros generally outweigh the cons, but there may still be other reasons why you, like me, may not want to use them as your retirement investing solution.
Pros of Target Date Funds
Let's start with the positives about target date funds.
#1 Simple and Easy to Use
The fund of funds structure means that you only have to select a single investment. A target date fund is a one-stop-shop. Solid, sophisticated investing can be very simple, and target date funds, like their cousins, life strategy funds, are the perfect example. One of the smartest investors I know, Mike Piper, uses a single fund solution for his retirement investing. Do not discount the majesty of simplicity. You simply pick the date you want to retire and match it to the fund. That's it. While many will argue that a target date fund may not be the best investment portfolio available, nobody will argue it is not a reasonable asset allocation that, if funded adequately, is highly likely to allow you to reach your retirement goals.
Perhaps the most important principle in investing is diversification. In short, you do not want to put all of your eggs in one basket. Predicting the future is notoriously difficult to do, and a diversified portfolio allows you to do well in a wide range of future economic scenarios. A target date fund automatically provides you a diversified investment portfolio/asset allocation. Not only does it diversify between asset classes by including US stocks, international stocks from all over the world, and bonds (and sometimes additional asset classes), but it is highly diversified within those asset classes by holding thousands of individual securities in each.
#3 Controls Behavior
In many ways, the investor matters more than the investment. The biggest risk to your retirement portfolio is you and your own maladaptive behavior. A target date fund minimizes this risk as much as possible. Since it is a diversified portfolio, it reduces the volatility of the overall portfolio and makes it easier to stay the course in a market downturn. Since the fund selects all of the asset classes, selects all of the individual securities, controls the asset allocation, and controls the glide path, all that is left for you to control is the most important thing—your savings rate, i.e., how much money you put in there each year. The target date fund focuses the investor on what matters most and takes care of everything else. It eliminates manager risk, individual stock risk, and market timing risk, all traps that many investors repeatedly fall into.
#4 Reduces Work
One of the best parts of a target date fund is that it reduces your workload. I know a cardiologist who spends an hour every day researching stocks. It's a bit of a hobby for him so he enjoys it, but that's still 365 hours a year, the equivalent of over two months of full-time work. Nobody using a target date fund has to do that. The professional manager selects the investments, automatically rebalances the account, and gradually reduces the risk of the investment along its prescribed glide path.
Given all of those huge pros, it is pretty easy to see the appeal of a target date fund.
Cons of Target Date Funds
There are, however, a few cons of target date funds, and it is a good idea to understand them before choosing this investing strategy.
#1 Loss of Control
The main advantages of target date funds are offset by their main disadvantage—you're not in control. Sometimes it is great to not have to be in control, but that does mean you are not in control. You can't select the investments. You can't select the asset allocation. You can't select the glide path. The professional manager does all that.
You can, however, work around this a bit. For example, rather than selecting your fund by your retirement date, you can simply look under the hood and select it by the asset allocation. Even if you want to retire in 2045, that doesn't mean you don't prefer a less aggressive asset allocation and cannot use the 2035 fund.
You can also add a fund to the target retirement fund. Chris Pedersen and Paul Merriman are fans of a “two-fund approach,” which is basically a target date retirement fund plus a small value fund. This provides the small value tilt that many investors want in their portfolios to try to take advantage of the long-term data suggesting that small and value stocks outperform the market in the long run due to behavioral and/or risk issues.
#2 Risk Tolerance Mismatch
The professional manager of the target date fund decides how much risk he or she thinks you should be taking at a certain time period before retirement. That may be less aggressive than you wish to be or more aggressive than you wish to be. For example, most of these funds start out at about 90% stocks and stay there for many years. That's pretty aggressive—more aggressive than many investors can tolerate. The professional manager may be controlling the asset allocation for you, but you still have to live with the consequences of what is selected. If you can't sleep at night or you can't reach your goals due to low returns, you're going to have a hard time staying the course.
#3 Bad Funds
Not all target retirement funds are created equally. The best ones have very low costs and are composed of passive index funds. The worst ones are expensive and stuffed full of actively managed funds that the mutual fund company is having trouble selling on their own. It's not that hard to just use the best funds (Vanguard, TSP, Fidelity Freedom Index Funds, Schwab Target Index Funds), but you do have to be a little bit careful. Note that both Fidelity and Schwab have non-index-fund based and index-fund-based target date funds.
#4 More Expensive
Investing in a target date fund is more expensive than “rolling your own” investment portfolio. With some target date funds the additional expense is obvious; they actually stack an additional fund expense ratio on top of the underlying funds. Neither Vanguard nor the TSP do that with their funds; you simply pay the weighted average expense ratio of the underlying funds. However, Vanguard does use the slightly more expensive Investor share classes of the fund rather than the cheaper Admiral share classes. This results in an expense ratio that is perhaps 5-6 basis points higher (perhaps 0.12% total) than it would be if you designed the exact same portfolio using Admiral share class funds. The TSP L funds do not do this and the fund of funds structure is essentially provided to participants for free.
#5 Lack of Availability
Many doctors have multiple investing accounts. It is not unusual for a doctor to have a 403(b), a 401(a), a 457(b), their spouse's 401(k), two Roth IRAs, and a taxable account. It would be unusual to have the same target date fund available in all of those accounts. If you are going to have to manage your own portfolio in one account, you might as well do it in all the accounts or there is little point in using a target date fund at all.
#6 Asset Location Issues
Doing asset location properly has the potential to add another 0.5% a year or so to your returns. This generally means placing particular assets into tax-protected accounts while other assets are placed in a taxable account. It can also mean things like using municipal bonds when investing in bonds in a taxable account. However, no target date funds use municipal bonds. If you're putting every asset class into every account, then by definition at least one of those asset classes is being held in the wrong place, eliminating the benefit from proper asset location. In essence, you're giving up a little return in exchange for simplicity.
#7 Performance Chasing
While professionals tend to be a little better at avoiding performance chasing than retail investors, they still do it. The asset allocation of target date funds actually changes from time to time in unexpected ways. Examples in the last decade include increasing the stock to bond ratio (which so far has helped returns) and increasing the international to domestic stock ratio (which so far has hurt returns). When you're not in control, you're not in control, and that has its pluses and minuses.
Who are Target Date Funds Right For?
So who is the ideal purchaser of a target date fund? There are several characteristics that make it more likely that this should be your investing strategy:
- Only one investing account. For example, for a resident who only invests in a Roth IRA, this is a great solution.
- The same TDF is available in all accounts. The fewer accounts you have, the more likely this is true.
- Values simplicity over slightly lower expenses and slightly higher tax efficiency.
- Highly values the behavioral benefits of TDFs.
What do you think? Do you use TDFs? Why or why not? Which one do you use? Comment below!