Target Date Funds – What You Should Know
You are 20 years old and just started working and contributing to your 401k at work. The brokerage firm you employer has partnered with offers target date funds for retirement among the various options available. Your goal is to work for 40 years and retire by 60. So, pick a fund, something like – “2055 Target Date Fund”.
Now, all you got to do is direct all your contributions towards this fund. The fund will take care of the rest – it will take care of the diversification, asset allocation across stocks and bonds, and also re-balancing the portfolio.
This sounds so good. You don’t have to do anything. Life is simple and easy. Put your money in this fund and just forget about it. All the hard work will be done by the people who run this target date fund. Honesty, I wish life were that simple. Believe me, I was naive to believe this for a few years in my life.
If this is what you have been thinking, let me burst your bubble right here and now. You must know the truth at face value.
#1 Expense Ratio
The expense ratio of target date funds averages about 1%. Expense ratio is basically how much the brokerage firm would charge you for every $1000 invested per year. Over a career of 40 years, this management fees can add up to a lot. You can read my recent post on how much does 1% cost you.
#2 Asset Allocation May Not Match Your Risk Profile
A target date fund is a one size fits all. Whether you are aggressive, moderate, or a conservative investor, it doesn’t matter. Once you pick your target date fund, the percentage mix of stocks and bonds is fixed for any given year.
For example, you may be 55 years old, the “2055 Target Date Fund” fund may have 70% in stocks and 30% in bonds. Your preference may to be to have 45% in stocks and 55% in bonds.
You have no control over adjusting the asset allocation. The asset allocation may not match your appetite for risk. To learn more, you can my recent post – asset allocation rule of thumb.
#3 Active or Passive Management
In general, the target date funds are not actively managed. However, the underlying funds might be. You will need to read the prospectus of the fund to determine this.
I am a fan of passively managed fund for their lower costs and better performance.
When you invest in a market index fund (like S&P 500), your investment matches market performance. Your fund follows the market. In this case, life is truly simple. You are guaranteed market return. Your investment is pegged against an industry standard benchmark which is a good thing.
How do you measure or benchmark a target date fund? There are so called target date benchmarks out there and honestly, nothing has stood the test of time.
My goal in this post was to drive full awareness of the drawbacks of investing in a target date fund.
If you don’t have any investment background, you are not the DIY type, and you don’t know any fee-only financial advisor that you can trust, then you are left with the only choice you have made – a target date fund.
#1 If you are the DIY type like me, you can move your investments to ETFs / funds with lower expense ratios. I will show you how I did my asset allocation in a follow up post.
#2 Hire a fee only financial advisor who can help you with asset allocation. Be very clear on what you want to accomplish (aka invest is passively managed index tracking funds with very low expense ratios) with your financial advisor and be willing to pay $300 to $500 to get your asset allocation in order.
If the advisor / advisory firm suggests you put your money in their secret sauce fund that is awesome, and only charges about 1%, button your wallet and run; find an advisor that will do exactly what you had in mind.
Walking away from target date funds will help you save thousands of dollars over your career – I say make the effort and it will pay off. Then, all you have to do is re-balance your asset allocation periodically.