Target Date Funds Pros And Cons

We have a lot of choices when selecting investment vehicles for 529 Savings Plan, 401 K retirement accounts and investment accounts.

Gaining In Popularity

Increasingly, target date funds have become popular with investors. Their assets surpassed $1 trillion in 2017. That trend is likely to continue. Vanguard, in its report “How America Saves 2019,” predicts that more than 75% of 401 K participants will be solely invested in these investments by year 2022. This is above 60% in 2019.

There are benefits and drawbacks of these plans to be aware of before making your selections. First, let’s explain what a target date fund is.

What Is A Target Date Fund?

These mutual funds, known as life-cycle, age-based, and dynamic risk, are offered by investment companies like Vanguard and Fidelity. Target date usually refers to the year you are planning to retire or expecting your child to enter college.

The notion of shifting your portfolio from aggressive investments to conservative investments has been around since the 1950s. However,  these life cycle funds grew in popularity after the passage of the Pensions Protection Act of 2006.

If you plan to retire in 2050, you would be investing in a “2050 Fund.” Your investments will be managed according to a predetermined allocation that will reset over the years. The time frame would likely be shorter for college savings funds but based on a similar concept.

A Glide Path For Your Asset Mix

Typically, your assets will be heavily invested in more risky assets like stocks in your younger years. Your portfolio will then be rebalanced to a more conservative allocation in your later years leading up to your presumed retirement date. The shift of these assets are often called a glide path. This means that the asset mix in the fund will automatically shift over time.

A target date fund invests in other funds, using a “fund of funds” approach. Morningstar points out that of the record high $70 billion that flowed into these funds, 95% went to passively managed ones which are generally lower cost options.

However, one fund may have a number of underlying funds that may be actively managed. If so, they will generally charge higher fees and may carry tax inefficiencies from the trading of positions.

Active investing means giving portfolio managers discretion to select individual securities with a certain investment objective of outperforming a specific index like the S&P 500.

Benefits of Target Date Funds

1. Simplicity

Choosing a target date fund takes the guesswork out of the investment process. The average investor may not have the knowledge or desire to actively do their own shifting of assets from an aggressive portfolio to a more conservative portfolio.

With over 90% of 401K employer-sponsored plans offering a variety of these “set it and forget it” funds, it may be less overwhelming for employees to opt-in to retirement plans. Many people have too little in retirement savings accounts.  The Economic Policy Institute “The State of American Retirement” reported that the vast majority of Americans have under $1,000 saved for retirement and half of all Americans have nothing saved at all.

At the very least, they are better off putting tax deferred dollars in 401 K plans and to start saving for retirement as early as possible.

These funds are also good for 529 College Savings account that use tax-deferred dollars like retirement accounts do.

2. Diversification

All investors should have diversification within their respective portfolios. You should never have concentrations in one particular stock or bond. Always maintain a diversified basket of assets composed of stocks, bonds, money market securities, and real estate. This helps to spread your investment risk among US and  international markets.

Each target date fund will differ in its diversification. You need to investigate its plan to understand how diversified it is and if  it is what you prefer. For example, you may not what to be exposed significantly to international markets.

Related Post: 10 Tips To Diversify Your Investment Portfolio

3. Asset Allocation

It is important to allocate your assets into different baskets according to your risk tolerance, age and investment purpose. Different asset classes have different risks. Target funds do this automatically for you based on their predetermined glide path. Each fund may rebalance differently and continuously to correct shifts in allocation to longer term.

If you are not in a life cycle fund, you are still able do this manually by actively shifting into different index funds, balanced funds, or individual securities. However, it is far more difficult and time-consuming. You would need to be more actively managing your own preferences.

Vanguard points out that investors who held a single target date fund earned a median annual return of 11%. This is modestly above the 10.6% returns of those individual investors managing their own portfolio.

How Does Allocation Work?

Vanguard, as one of the largest investment companies, has target funds that go out to the year 2065.  For example, we can look at 30 year target date funds and see how it rebalances asset classes.

The initial asset allocation in Vanguard’s fund may be 85%-90% stocks and 10%-15% fixed income (a mix of short term money markets and bonds). This is considered to be an aggressive allocation given the riskier (and higher return) characteristics of stocks.

The Vanguard stock allocation may then drop to 80% stocks and 20% when there is 20 years left to the targeted retirement date. At the target date, the allocations may shift to 45% stocks and 55% in fixed assets reflecting a more conservative portfolio with more bonds than stocks at the time of your retirement.

These percentages tend to be static but funds may buy or sell securities to maintain the asset ratios.

T Rowe, another great investment company, tends to allocate more stocks for their portfolio in the later years. For example, its 2020 fund holds 55% in stocks versus a 43% average for target date funds according to Morningstar.

Drawbacks of Target Date Funds

1. One Size Doesn’t Fit All

The conventional wisdom is that younger individuals should invest more of their savings in riskier stocks. As they age, their asset allocation should transition to safer, more conservative assets, notably bonds and money market securities.

This has generally been true, considering that younger investors have longer time horizons to ride out market volatility. Additionally, they have more years to work and generate earnings.

However, there are certain trends that tell us target date funds aren’t for everyone. Individual investors may have too much risk or too little risk relative to their own circumstances.

2. Greater Income Volatility

Increased household income has become less predictable since the 1970’s. A 2012 study “Evolution of Household Income Volatility” reports that family’s inconsistent income has risen 30% since the early 1970s. This occurred as a result of a number of factors, notably deregulation, globalization, technological advances and the onset of the financial crisis and Great Recession.

If you are among those who have monthly swings in income, higher allocation in stocks may not necessarily be desirable for you even if you have a longer time frame to ride out downturns. Your goals may be different in terms of savings and investing.

Related Post: Related Post: 10 Tips To Handle Stock Market Volatility

 3. Retirement Age May Be Going Up

“Full retirement age” has moved up a few years as reflected in that our ability to collect 100% of our social security benefits. It has now been raised to at 67 years. Many educated older workers are also working well beyond 65 years. In any case, it is difficult for anyone in their 20s and 30s to contemplate their target date with accuracy.

4. Higher Life Expectancy

Due to many medical advances, people are living longer. Security Administration has a life expectancy calendar that you can use to calculate life longevity for men and women. A man reaching 65 years today may expect to live to 84 years while women may live to 87 years. Some studies show longer life expectancy especially if you are younger today.

As such, target date funds may need to lengthen our investments. Perhaps they can be tailored to the reality of longer or different life cycles so there will be enough retirement money to live on.

5. Fees On Funds Are Confusing And Potentially Excessive

Before picking an age-based fund, review their fee structure as they vary quite a bit. Vanguard target date funds are truly the gold standard. Their asset weighted fees are the lowest. They range from 0.09% for the funds that target retirement in year 2040, rising to 0.15% for their 2065 fund.

In contrast, asset weighted fees on target date funds offered by Fidelity and T Rowe are relatively reasonable at 0.61% and 0.69% respectively. That is roughly in line with the 0.66% fee as measured by Morningstar. Be wary of possible excessive fees charging rates of 1% or higher.

Two Layers of Fees

Many target date funds are funds of mutual funds. Investors may be charged two layers of fees. One fee is for target fund and another for the asset-weighted average of the management fees of underlying funds. Essentially, you may be overcharged for what amounts to computer-driven asset allocations based on a calendar.

6. Target Date Funds May Underperform Other Funds

Some studies have shown that 50/50 balanced funds, meaning allocations of 50% stocks and 50% bonds may perform better than target-date funds. Balanced funds charge lower fees.  A study done by Rob Arnott of Research Affiliates used Monte Carlo simulations for 1871-2011.

Monte Carlo simulations are used to understand the impact of risk and uncertainty in prediction and forecasting models. This study reflected the outperformance of gains of $170,480 for balanced fund versus $159,130 for target date funds.

7. No Guaranteed Returns

It is important to remind investors that these funds do not guarantee returns. The formula-driven rebalancing and respective returns of different securities may suggest otherwise to investors. As such, 30% of investors believed these funds carried assurances of guarantees according to a survey commissioned by the SEC.

Final Thoughts

Target date funds have a role to play in the individual investor world. As always, when something seems too simple, it usually isn’t so. It is a great way for people who are sitting on the sidelines and neglecting to save for retirement. These funds are a good way to participate and you can make changes later on.

When it comes to employer-sponsored 401 K plans, find out what the minimum amount you need to contribute to potentially get a match contribution. That’s like finding free money.

Check the features of the various offerings available from the investment companies. Look at the asset mixes through the life cycle and how it conforms to your financial needs. Make sure the expense ratio you will be paying annually is not too high. I believe Vanguard’s funds are preferable for reasons mentioned above but there are plenty of choices out there to consider.

It might be wise to consult with your financial advisor or planner regarding your choices when it concerns target date funds for your retirement.

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Have you invested in a target date or life cycle fund for 529 savings or retirement accounts? What kind of experience have you had?