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Today's WCI Network post is from The Physician Philosopher. Like TPP I don't hate target date funds but I also don't use them in my own portfolio for the reasons he discusses below.]
While TDFs offer some tangible benefits, are they the right choice for you? Here are several pros and cons of TDFs to help you answer that question.
First, let’s cover some basics.
What Is a Target Date Fund?
A TDF is a “fund of funds”. In other words, it is a single investment that invests in multiple other funds. Often times the funds within these accounts are actively managed funds as opposed to passive index funds, though that isn’t always true.
Each fund has a different “target date” that you can select for your anticipated retirement date. If you are 35 years old, the year that is automatically selected for you by your employer is likely 30 years from that day.
For example, if you are 35 in 2020, your target date retirement fund might be the “2055 Target Date Fund”, because you anticipate retiring at age 65, which would be year 2055.
In your younger years, these funds will assume more risk with a higher stock to bond ratio. As you get closer to retirement, your asset allocation within the fund will automatically shift towards less risky asset classes like bonds.
Pros of Target Date Funds
TDFs offer a lot of advantages and may be the right choice for you. Specifically, here are a few advantages offered by these funds, and how you may benefit. [Make sure to keep reading to the end, though, because these funds have some drawbacks, too!]
1. Set It and Forget It
Those who have read The Physician Philosopher’s Guide to Personal Finance know that I am a big fan of “set it and forget it” personal finance. This is by far the biggest benefit of these funds. You can determine how much you want to put into the fund each month, and then the TDF does the rest.
For example, the fund will automatically change your asset allocation as you get older. You don’t have to do that yourself.
In this way, a TDF is very appealing. You don’t even have to look at your 401(k) to make sure things are where they should be, because the fund does it all for you. In this way, these funds are pretty hands-free.
2. Target Date Funds are Diversified
TDFs are typically very diversified.
These funds usually contain a mixture of stocks to bonds which will vary as you age. In addition to this, they have both domestic and international exposure. If you include both stock and bond funds, most target date funds that I have seen have 20-40% of the assets in international assets.
In this way, you can have a set-it and forget-it investment that is highly diversified.
3. Automatically Rebalance
For those of us who don’t invest in target date funds, we have to rebalance our portfolios each year. I do this annually in January to make sure that my actual asset allocation doesn’t get too far away from what I want.
For example, we currently aim to have 90% in stocks and 10% in bonds. Given the success that stocks have had in the last two years, I often find that I am closer to 95% stocks and 5% bonds by the end of the year. So, each year, I transfer some of my money within my retirement accounts to get back to our 90%/10% ratio.
If you invest in a target date fund, you don’t have to do this if that fund is all you own. The fund will do it for you. This is yet another example of how a target date fund can serve as a set-it and forget-it method for investing.
Cons of Target Date Funds
With all the positive aspects of TDFs, you may be surprised to find out that I actually don’t use them in my portfolio.
Here are some of the drawbacks of these funds.
1. Risk Tolerance Varies
Your risk tolerance is likely different than mine. Yet, if we invest in the same fund, then we will have the same asset allocation even if I have a much higher (or lower) risk tolerance than you.
This isn’t ideal when the name of the game is to “stay the course”.
In other words, if you want to take more risk, and my TDF doesn’t take enough, you may be inclined to make changes. The opposite is also true. If the TDF takes too much risk, you may be inclined to sell during a down market. Of course, this would be a financial catastrophe.
This one-size-fits-no-one approach to investing makes target date funds less appealing for people who want a specific asset allocation.
2. High International Exposure
Most TDFs that I have seen have a very high international exposure that is usually >30% of the portfolio if you include both stocks and bonds. If this is your intended asset allocation, that is perfect!
Personally, I aim to have 10-15% of my portfolio in international funds. So the higher international exposure, which has historically underperformed domestic investments, is not ideal.
Remember that every target date fund is different, but this is worth checking into if you are currently invested in one of these funds. If you don’t want 30-40% of your portfolio exposed to international investments, it may be time for a change.
3. More Expensive
This “con” is only half true. Some of these funds are very expensive while others – like those offered by Vanguard – cost less.
For example, the average expense ratio on most target date funds is 0.4% to 0.5% while Vanguard offers some of these funds for as little as 0.15%.
4. Multiple Accounts = Wrong Asset Allocation
The right asset allocation looks different for everyone. Regardless of what yours looks like, the aim is to have your entire savings portfolio – including every single investment account – reflect that asset allocation as a whole.
One of the big problems with TDFs for high-income earners is that, when you are in your peak earning years, you will likely be saving much more than the $56,000 you can save in your 401(k). For example, my family’s annual savings goal is north of $100,000. For this reason, less than half of our annual savings is within my 403(b) at work. If I relied on a target date fund inside my 403(b), I would then have to do the math to make sure my other accounts reflect our desired asset allocation.
This actually makes rebalancing and asset allocation more difficult.
The issue is that TDFs assume that they are your only investment and make adjustments along the way based on that. While you will have to rebalance your asset allocation regardless, having a target date fund in one account and not in others can complicate your rebalancing needs.
Should You Use Target Date Funds?
Like anything else, target date funds have distinct advantages and disadvantages. If you like the easy approach to these funds, they may suit your needs.
Ultimately, TDFs are appropriate for people in the following situations:
- Your annual savings goal is entirely held within your TDF.
- The target date fund you invest in is available in both your retirement and non-retirement accounts.
- Investing in target date funds will allow you to “set and forget” your investments so that you are less likely to make a change.
For others who want less international exposure, lower cost, and a specific asset allocation, you may be inclined to avoid these funds.
Do you use target date funds? Why or why not? Leave a comment below.
Advised my kid (and about to so advise kid2) to use this for diversity, one fund with low amount to invest, with different target date (forget if they had one aimed at even YOUNGER than her for more stocks in mix) for ‘more’ risk than one for her age. Can’t recall if she does it in an IRA or what. When they have more money to have minimum purchase for more funds will recommend 3 fund type plan at our favorite place Vanguard. Sadly don’t think them being my kids (Admiral group etc for us parents) lets them forego minimum deposits- ? $3K or in IRA $500 IIRC. Though guess starting 3 funds with $100 or so in each for a 20 something who might change mind and empty it next year WOULD be silly.
I use a TDF in my Roth IRA w Vanguard. I completely agree w all the pros and cons listed above. The only reason that o used this TDF is because when I contributed to the Roth, it was my last year of training and the amount contributed was too low for most other funds. This is another advantage of TDFs although I do not contribute to any now. My financial plan calls for essentially ignoring this account when it comes to asset allocation to keep things simple.
Great overview!
The Prudent Plastic Surgeon
Nice post. I personally think Vanguard TDFs are a great option for >95% people out there. Keep it simple stupid.
Agree that as you run out of tax sheltered space and mature as an investor, you will likely start to drift away from TDFs.
Only place I disagree with the post is the last point about multiple accounts/asset allocation.
If you use a platform such as Personal Capital it is easy to visualize your asset allocation across all accounts including the funds within the TDF, which makes rebalancing pretty easy if you want to use a mix of TDF and non TDF.
Maybe a post for a different day: TDF plus small cap value. “2 funds for life” from Paul Merriman and Chris Pedersen. Not sure how I feel about this strategy. I currently tilt small cap value for 10% of my equity holdings (90/10 total equity/fixed income). The 2 Funds for life would put me in a LOT more SCV. Tax loss harvesting would “probably” still be legal switching back and forth between different SCV funds and ETFs if this 2 Fund strategy was utilized (and maybe there would be more opportunities for TLH given higher short term volatility of SCV).
Interesting that Personal Capital can track the true AA despite using TDFs.
In my experience people who want “2 funds for life” are not the same people interested in tax loss harvesting.
I’ve been very impressed with Personal Capital’s ability to track asset allocation within TDFs. It seems to have no problem with the TDFs that I’ve used at Vanguard, Fidelity, Schwab, American Funds. Sometimes your have to manually tell it what fund is which, but after that it does all the legwork.
Good point about International allocation. I heavily use Vanguard TDF’s but have been a little uneasy about the relatively high level of international allocation.
One would assume Vanguard has done their analysis and have made these allocations based on their research. And believe it provides the best risk/return balance.
So not sure who has it right, these large brokerage houses and their research teams or WCI/TPP.
Probably no one knows with enough certainty.
I’ve been tempted to decrease international exposure given the underperformance over the past decade and longer. But have note done so thinking it might be kind of like selling low.
Someone posted this explanation on the author’s comment section as to rationale for international holdings
https://movement.capital/summarizing-the-case-for-international-stocks/
Insterestingly, Bogle never bought into this idea
Bogle said 0-20%. Vanguard says 20%+. That’s the reason Taylor Larimore cited in his book for recommending 20%!
What do you mean “right”? I think a reasonable international allocation is 20-50% of stocks for a US investor. Personally, I’m 33%. Last I checked Vanguard’s TDFs were about 40% international. Seems like about the same neighborhood to me.
Your last statement sounds like market timing to me. If I had to make a bet, I would bet that international will outperform US over the next decade. I would also bet that value will outperform growth, small will outperform large, and non-tech will outperform tech. But I’m not really betting. I’ll have the same asset allocation for the next decade as I had for the last one.
Thanks for your input Eric and Jim. Eric, that was a helpful reference.
Jim to answer your question on what I mean by “right”. At the beginning of the blog, you mentioned that you don’t invest in TDF’s for the same reasons TPP outlined. One of the reasons outlined was high international exposure. I inferred that you try to avoid high international exposure as well. But it sounds like you are in the same ballpark as Vanguard with exposures.
I think one difference may be that Vanguard has International Bond exposure which I believe you aren’t a fan of. Both you and Vanguard are excellent resources, but there is some difference.
Sorry if my question is too nuanced, I enjoy the academic exercises of Personal Finance.
Thanks.
Ahhh…that makes sense. Not actually an issue for me.
I don’t really have a problem with international (hedged) bonds, but I don’t have them in my portfolio for simplicity reasons.
The truth is nobody knows if 20% or 40% is right. The truth, however, is that the key is that you pick a percentage and stick with it. That matters a lot more than what the percentage is.
One pro not mentioned is that the TDFs provide a liability shield against fiduciary complaints. I manage the defined benefit plan for my wife’s employees, and I do a weight based single allocation to a TDF targeting age 65 retirement. You can argue, looking at 2008, that TDFs are way too stock heavy for many conservative investors (ie the ave person), who can’t risk a 30% drop early in retirement (See Bodie & Taqqu “Risk Less & Prosper More”) But in my situation, it definitely makes life easier, without hiring another fiduciary to do the work.
Not sure but a balanced fund probably provides a similar shield. (btw this is a re-post of what I put on the author’s site)
A great point. I also find it hard to believe one could get sued for not fulfilling their fiduciary duty for providing a 401(k) filled with low cost index funds.
Another disadvantage: TDF’s don’t allow tax efficient fund placement.
Are Vanguard target date funds considered “actively managed” funds? I know active management is generally discouraged.
I would not consider them “actively” managed. Most are 3 or 4 fund portfolios. Pay a small fee premium to have someone else rebalance for you.
No, they’re a fund of funds of index funds.
For money that I rarely add-to, and is tax-advantaged, I use TDF+SCV fund (2fundsforlife.com): This is in my personal Roth IRA (annual backdoor lump sum contribution)… this way I don’t have to worry about rebalancing with the rest of my investments. The TDFs for these Roths are a bit farther out in time than my expected date — as these accounts may be the last ones I access.
In my employer 401K and taxable investments – in which I have regular in-flows of money, so rebalancing across that spectrum of accounts helps me have the factors/classes I want to have — I have a broader number of index funds.
All good points.
The biggest problem with TDFs is the assumption that everyone reduces stock exposure at the same rate based soley on age. Ignores the rest of your assets, whether you are still working, any pension or annuity income…
We don’t plan to reduce stock allocation with age at all. For diversification we would be better off in a balanced fund that does not change asset allocation over time.
Also, with a TDF, you have to accept the portfolio composition the sponsor chooses. A while ago you would not have any international bonds because Vanguard did not have a fund. Now you get those bonds whether you want them or not. Vanguard says the considered adding commodities but has decided against it, at least for now. If you pick your own funds, then you don’t have to worry about what changes the manager may make.
Vanguard’s Life Strategy funds don’t change asset allocation.
I wanted to share one hidden danger of TDFs not mentioned here. When someone is a few years away from retirement, or in the first few years, there can be trouble if a majority of their assets is in a TDF.
Let’s say they need withdrawals while the stock market is down 40%. They are forced to sell the TDF, thereby selling both stocks and bonds. So they are selling stocks at lows when, in many cases, it could have been better to sell only the bonds. Therefore, I generally advise to break out the TDF into component stock and bond funds 3-5 years from retirement. Great post!
Another excellent point.
Great point! Possibly the best argument against using TDFs.
Jeff’s argument against a TDF is not correct. When you withdraw money, it doesn’t matter if you withdraw first, then rebalance, or vice-versa. In his example with the market (aka equities) going down significantly, the investor will be selling their bonds (rebalancing) on the way down. The TDF would be doing the same; inflows would be purchasing equities, and outflows would be selling bonds and they may also rebalance. The performance of those approaches is going to be terribly similar and any differences will be due to how the TDF handles rebalancing and maintaining the allocation versus how the individual does this.
Since posting and comments are turned off on random webpage places (this page works I guess?), you might want to shut down the political bickering on forum.l about COVID.
There’s nothing random about which posts on this blog don’t allow comments. But there’s only been one post in the last yeqr where they were turned off. It ran on Monday. If you go back to the comments on past announcements of scholarship winners you’d know why they’re turned off.
At any rate, the forum has a policy against political bickering and COVID threads, so rather than leaving a comment here that I’ll see in a few days when I get back from the lake, why not DM a moderator on the forum? They’re very good and they’re on there far more than I am.
Also, if you are easily offended/bothered by what your read, be sure to stay out of the “lounge” area of the forum.
Great point! Possibly the best argument against using TDFs.
My money is literally in the process of moving from one 401k account to my companies new account. The new TDF available to me is different but does have a lower expense ratio then before. Although it is not as low as Vanguard’s, I do love the ability to set it and forget it.
I do invest in Vanguard’s TDF as well so I will have to complete an asset allocation evaluation to ensure they are balancing well with each other.
Thanks for the pros and cons list.
When my wife and I got married in 08 I started our Retirement accounts using vanguard target funds for both of our 403B and vanguard 500 fund for our Roth IRA’s.
I decided to build my own portfolio but kept my wife’s in the target fund. We each max out our accounts. I compared our 5 year returns as I started my own account a little over 5 years ago.
Her 5 year return 9.99%
My 5 year return 9.22%.
And both our Vanguard S&P 500 Roth accounts 14.0%
TDFs are specially suited for people who don’t have any inclination to learn about investments. But they are still a great product for most people.