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.

 

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#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.

 

#4 Benchmark

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 Opinion:

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.

 

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8 thoughts on “Target Date Funds – What You Should Know”

  1. Very useful article.. after reading this article I went back and looked through my options for 401K.. and found “Vanguard 500” (VFIAX) with very low expense ratio and a high yield %.. So it should have been a no brainer for me to have gone with this one.. but other than these 2 parameters, is there anything else that I should be looking for… just a doubt because it looks so obvious

    1. I checked Vanguard 500 (VFIAX). It seeks to track the S&P 500 index performance. Yes, that should be a no brainer.

      Secondly, you need to determine your asset allocation between stocks and bonds – please read this post – http://stretchadime.com/asset-allocation-rule-of-thumb/. This is what I currently follow.

      You can see how I have currently done my retirement asset allocation at – http://stretchadime.com/my-retirement-asset-allocation/.

      You will notice that I have invested across U.S. domestic stocks and bonds and international (developed foreign and emerging market) stocks and bonds via ETFs. I do not have any REITs in my mix. Some people have REITs in their mix as well. At this point, I don’t feel a need for it.

      You need to be comfortable with your stock / bond allocation and the associated risk / reward trade off.

      Wish you good luck!

    1. Yes, I was invested in target date funds. As I mentioned in my earlier post, the target fund I had my investment in at that time was doing fairly well and I wasn’t losing sleep over it.

      The fund was with my former employer. I finally decided to transfer my 401k from my former employer and rolled it over to an IRA where I have more freedom.

      When I did the transfer, I researched more on target date funds and hence this post. You can see how I have currently done my retirement asset allocation at – http://stretchadime.com/my-retirement-asset-allocation/.

      Thank you for reading, giving me feedback, and holding me accountable. I really appreciate it. Thank you, Franklin!

  2. Not a bad article, but failed to take into accounts lots of details. For example, lots of 401ks have *REALLY* affordable target date funds. My company for instance offers LifePath Q shares with a 0.11% expense ratio. That’s almost as cheap as their total market index fund option (offered at a 0.09% expense ratio). Their cheapest International fund is 0.78%… Plus the available bond fund options aren’t exactly stellar (just one fund). Hell, their money market is a 0.18%. Building an internationally diversified and balanced portfolio by picking ala cart funds and doing one’s own asset allocation strategy with minimal set of choices of funds is often a sub-optimal strategy. The article’s point about asset allocation diverging from your actual risk profile is good one, but the article failed to point out that just because you might plan to retire in 2040 doesn’t mean you have to be invested in the 2040 target date fund. You can choose whichever target date fund you want that offers the asset allocation balance you see fit (I’m in a 2035 fund, even though I plan on retiring within the next 10 years or so, probably earlier). Now, every year, that balance can (and likely will) get readjusted to be slightly more conservative, but in general that’s exactly what you’d want, and if you didn’t you can just switch to a different fund that does have the allocation you’d want (e.g. 2045 fund).

    1. Hi Will, Thank you for your feedback! I appreciate your thoughts / feedback. Here are a few things to consider:

      (1) Not everyone has the choice of affordable target date funds – in my case, I am paid well, however the target date funds in my 401k have very high expense ratios – so I chose to go with S&P 500 index fund with my current employer. I do understand that the fund choices in a 401k are limited and you might not be able to do exactly what you want – that can be very frustrating. I ‘m actually going through that pain now.

      (2) I rolled over my 401k from my former employer into an IRA – here I have full flexibility to do whatever I want – you might be interested in taking a look at my current asset allocation – http://stretchadime.com/my-retirement-asset-allocation/ – it is performing well and I am very happy with it.

      (3) As I mentioned in the post, how do you measure / benchmark performance of a target date fund? – every broker has their own chocolate cake recipe called target date fund and they all taste different. If you need to understand the target date fund, then you need to look at the underlying funds – by the time you go through this exercise, you might like or dislike the underlying choices. If you have gone through all this pain, you might as well start with a clean sheet and do your own asset allocation.

      (4) My comments apply if you are DIY type person like me. However, if you are not interested in investing, then a fee only advisor could optimize your asset allocation. The last resort of course is the target date fund.

      I hope to see more of you here.

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