KISS
Amazingly, given my well-documented love of the retirement target date fund, I have never posted a blog wholly devoted to the topic in this forum. Until now! From where does this affection spring?
Let’s start with the basics. A target date fund (TDF) is a mutual fund that holds a collection of other funds; it is a “fund of funds.” Often the word “target” is even in the fund title; a notable exception would be the TSP Lifecycle fund family. (TSP is the defined contribution retirement plan for federal employees.)
Because a TDF is a container of several funds of different types, it provides an “all in one” solution to achieve both asset allocation (a mix of stocks and bonds) and diversification (different types of stocks and bonds). And that’s incredibly important, as I am sure you have heard countless times before.
The way a TDF is presented to you, perhaps in the menu of your 401(k) fund choices, is according to the year that you will turn 65, which is meant to be analogous to your retirement year. (I’ll return to this point later.) So, if you are 45 years old today, you would be guided to select “XYZ Brand Target Date Fund 2045”, because 2045 is about 20 years from now and that is when you will be (almost) 65 years old. (TDFs are offered in 5 or 10 year increments.)
Different mutual fund companies have different philosophies about how to construct a TDF, but the divergence isn’t usually dramatic. In our example above, a typical 2045 Fund might hold today a portfolio that looks something like this:
50% US Stocks (both large and smaller companies)
35% Non-US Stocks
15% Bonds
Then, ever so gradually, the composition of the TDF will become more conservative as the target year approaches. (This is called the fund’s “glide path.”) By “conservative,” I mean more bonds and fewer stocks. This is meant to reflect the fact that when the time comes to begin making withdrawals from the account, you will likely want less market risk in your portfolio. You will likely prefer a more stable portfolio at that time. (Again, this is a point I will return to later.) So, come 2045, that same fund may look something like this:
30% US Stocks
20% Non-US Stocks
50% Bonds
Why do I love TDFs so much? Because they take most of the work out of investing. A well-constructed, low fee TDF (yes, again, a point that I will return to) provides both proper asset allocation and diversification, and continues to do so automatically as you age, without you having to lift a finger. It really is a one-fund solution, as I described here.
So why do they sometimes get a bad rap? TBH, I am reasonably certain that a good deal of the “anti” arguments are driven by financial advisors’ interest in selling their expertise to you. But there are certainly some pitfalls to TDFs. The good news is that these pitfalls are usually easily avoided with just a modicum of considered thought:
Your “assigned” fund may not actually correspond to when you will take withdrawals from your account. Perhaps you plan to leave employment early when you are 59 ½. In this case, you may want to select a fund that has an earlier date than what is commonly recommended to account for the fact that you will begin distributions “early.”
Alternatively, you plan to work into your 70s and beyond. Or regardless of when you stop working, you have no plan to take meaningful withdrawals from the account. You plan to live off your Social Security income and a pension, and you see your retirement account as mostly “extra.” In these cases, you may prefer to select a TDF with a later date, meaning that it will be invested more aggressively (i.e., more stocks, less bonds).
Both of these are examples of investors who have a different investment risk capacity than average. But it may be that you have a non-standard investment risk tolerance:
You are young and the TDF’s calendar says that you should be 90% invested in stocks based on your age. But you are also the person who gives serious consideration to going all-in on tinned fish as an investment asset whenever the stock market wobbles. For you, selecting a more conservative TDF year could be a great solution.
Or you are simply not at all risk averse. Your investment style is to swing for the fences every day, and you are fully prepared to live through big fluctuations in market returns. For you, a TDF with a later date could be an excellent choice, allowing you to be more aggressive and yet still always well-diversified.
In short, the year that you turn 65 is only a starting point for choosing the “right” TDF. You still need to bring a bit of critical thinking to the table.
The other complaint I hear about TDFs is the cost. Quick tutorial: A mutual fund’s cost is expressed as its expense ratio. An expense ratio of .05% means that for every $10,000 you have invested, you will pay $5 annually. So, if your 401(k) balance is $100,000, the annual cost is $50.
TDFs can have a higher expense ratio than their underlying funds. [1] You can think of this as a management fee to the robot who rebalances your portfolio. But is this really an apples-to-apples comparison? Just to use a typical Vanguard TDF as an example, it carries an expense ratio of .08%. The underlying funds have expense ratios ranging from .02% for the US stock index fund to .17% for the international fund. So, yes, the cost is higher than buying just a US index stock fund…but the cost is not necessarily higher than if you constructed a multi-fund portfolio on your own.
But even in cases where the TDF fee is clearly above the cost of buying several funds individually (for example, in a 401(k) plan where the fund choices within the TDF may be different than the fund choices outside of the TDF), you still need to balance that cost with the service that the TDF is providing. If you are happy to choose your own funds and rebalance your allocation annually (and adjust as you age as your risk capacity diminishes), by all means have at it! Really, a lot of people find this to be highly enjoyable. But if reading this blog has already made your eyes glaze over, then DIY portfolio construction is probably not for you.
Yes, I have seen workplace retirement plans that are littered with egregiously high fee (high expense ratio) TDFs. However, in these cases, the non-TDF options are usually not terribly attractive either.
It’s a bit of a non sequitur, but I need to address recent developments in the TDF space. There is a move afoot to allow employers to add private equity and private credit funds to the TDF mix. It’s a bit astray from the point of this particular blog, but I invite you to read my thoughts on this on my Facebook page. (I expect to have much more to say about this in the future!) Spoiler Alert: Don’t fall for the hype.
(Hey, I’d love to be in touch regularly. My free newsletter contains this blog, as well as other articles written by myself and others. Please consider subscribing by visiting the MoneyByLisa home page.)
[1] But not always! TSP Lifecycle funds are an example of a TDF that does not mark up the TDF above the cost of the underlying funds.