Pros and Cons of Target Date Funds | White Coat Investor

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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.]

When you start saving money in your employer’s retirement account, most employers automatically place your money into one of their Target Date Funds (TDF).  Because of this, the use of TDFs has continually increased through the years.  In fact, Vanguard has shown that 77% of participants use a TDF and 52% of people have their entire portfolio in a single TDF.

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%.

It is worth noting, though, that all of these funds are more expensive than the expense ratios you would experience with a simple three-fund portfolio where you managed the asset allocation yourself.

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.