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
- Diversified
- 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.
#2 Diversified
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!
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.
I like the idea of 2 funds, but I don’t have access to small cap value in my tax-advantaged plans, so I use a mix of 80% TDF+20% large cap (vanguard sp 500), I plan to rebalance every year and stick with that percentage, Paul Merriman suggested SCV to add to TDF and I know the data behind it but I believe the Draw down will be more with the SCV and I feel more safe with large cap around retirement
That’s like the opposite of Merriman’s 2 Fund solution since you’re not only not tilting toward small value stocks, but actively tilting away from them!
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.
I’m probably missing something obvious (newbie here) – why are TDFs best if you hold only one investing account? Can’t you place $ in a TDF for each account (one 401k, one Roth, etc) and basically let them do their thing? Is it the rebalancing that would be difficult? Thanks!
If the TDF is available in ALL your accounts, it’s probably fine. And there’s always something nice about simplicity as discussed here:
https://www.whitecoatinvestor.com/in-defense-of-the-easy-way/
I opened a Roth IRA during school and residency and invested in a Vanguard TDF. Now, working in private practice, I have done a backdoor Roth IRA for the last 2 years, still investing into the same TDF. As a disclaimer, I’d consider myself a relatively new but enthusiastic WCI…I still have a lot to learn, but I’m getting much more fluent in terms of looking into fund performance, expense ratios, tax cost ratios, etc of my investments. My preferred funds are now indexed mutual funds, but when I started my Roth, the simplicity and diversification of a TDF was appealing. I’m curious to get input on whether there’s any value in moving my investments in the Roth (or at least invest later contributions) to a fund other than a TDF to try to decrease expense and increase returns? My typical approach is to invest and not touch the money to let it grow…that said, if I’m continuing to invest in backdoor Roth each year, I’m still early in my career, and maybe a fund other than a TDF would be more beneficial in the long-term.
Curious to hear thoughts on this point, thanks!
Sure, but it’s not much value. TDF funds already have a pretty low expense ratio. But you can get it slightly lower if you’re willing to be slightly more hands on.