The Problem With Target-Date Funds
One size doesn't always fit all.
Index funds promise simplicity in investing, allowing you to build a complete, diversified portfolio with up to three funds. Target-date funds promise even more simplicity by collapsing your decision to one fund.
A target-date fund is a mutual fund or ETF that invests in both stocks and bonds designed to start aggressively and gradually become more conservative by increasing its allocation to bonds as the target date approaches. This allows people investing for retirement to select a single fund according to their desired retirement year, for example, a target-date fund designed for those retiring in 2060, and not have to worry about managing multiple portfolio holdings.
Even though they’re mainly designed for retirement, you could use target-date funds for any goal with a specific end date in mind, like college.
Target-date funds may be actively or passively managed. Many target-date funds are funds of funds, meaning the fund invests in other funds rather than holding stocks and bonds directly. For example, the Vanguard Target Retirement 2060 Fund invests in four Vanguard index funds: 54.3% in the Vanguard Total Stock Market Index Fund, 36.1% in the Vanguard Total International Stock Index Fund, 6.7% in the Vanguard Total Bond Market Index Fund and 2.9% in the Vanguard Total International Bond Index Fund.
Target-date funds are a popular choice for many investors, and they’re often the default choice in workplace retirement plans, but they have their problems.
Before I get into the problems, let me highlight some of the benefits of target-date funds:
1. They’re Simple
A target-date fund gives you a diversified portfolio with one fund. If you don’t want to learn about a three-fund portfolio or you stress about having to decide between bonds, whether to invest internationally and what percentages to allocate, a target-date fund is a quick and easy solution to these worries. Simply invest in the fund closest to your desired retirement year, continue adding to that one fund and never give your investments another thought.
2. You Don’t Have to Rebalance
Even if you select an asset allocation, your investments are bound to drift, as some investments grow to become a larger or smaller percentage of your portfolio through normal market movements. Every so often, maybe once a year, you may want to rebalance your portfolio to bring it in line with your asset allocation. A target-date fund handles this all for you with no need to rebalance.
3. Helps You Get Started
A target-date fund may get someone started in investing that otherwise wouldn’t. If that’s you, invest in a target-date fund. You can always decide later to put together a custom portfolio.
4. Takes Out the Emotion
Because target-date funds are automatic and decide your asset allocation for you, they take the emotion out of investing, since they are designed for one-fund portfolios. You’ll be less tempted to time the market if all your assets are held in a single fund.
Now here are the problems:
1. Higher Fees
Target-date funds tend to have higher fees than index funds. This is especially true for actively managed target-date funds, although with Vanguard’s they are almost identical to the fees you would be paying if you just invested in the underlying index funds.
2. A One-Size-Fits-All Approach
Target-date funds take a one-size-fits-all approach, but they fail to account for different situations. You may expect to retire in one year but life events can shift your plans. Relying on a single target-date fund and paying no attention to the underlying allocation reduces your flexibility.
3. Too Conservative Too Early
Target-date funds get too conservative too early. For example, the Vanguard Target Retirement 2020 Fund invests in 54.2% bonds. It’s usually a mistake to invest so heavily in bonds, even at retirement age, because you still need growth assets to get you through what could be a multi-decade retirement.
4. Heavy International Allocations
Some target-date funds have heavy international allocations. Vanguard’s target-date funds contain 40% of their stock allocations in international stocks. While that’s the correct global market cap weighting, investors may want less international exposure. In that case, putting together a three-fund portfolio and determining your own international allocation may be a better option.
5. Bad for Taxable Accounts
Their sometimes heavy bond allocation makes target-date funds tax-inefficient, meaning you should keep them out of your taxable brokerage account. Vanguard recently drew criticism for making changes to their target-date funds that resulted in huge tax bills for investors holding them in taxable brokerages.
Concluding Thoughts on Target-Date Funds
A target-date fund promises a one-size-fits-all option, but it doesn’t always deliver. If you do decide to invest in a target-date fund, make sure you understand what the investments are and if you’re comfortable with them. If you want a more aggressive allocation than a target-date fund provides, choose one further out from your actual retirement date. If you want a more conservative allocation, choose the fund with a closer retirement date. Also, make sure the target-date fund you’re investing in is passively managed rather than actively managed to minimize fees. And keep them in your tax-advantaged accounts to avoid higher tax bills.
I don’t invest in target-date funds, and probably never will for the reasons I’ve listed. I prefer to have more control over my investments. If you choose to invest in a target-date fund, you could do worse. But you could also do better. And that’s why if someone asked me for advice, I would do my best to explain to them a simple three-fund portfolio.
Choosing a target-date fund isn’t necessarily a bad choice. They can help you invest without having to make decisions some investors may find stressful. If you have a better grasp of your risk tolerance and your goals, you’ll be able to make more informed decisions about whether they’re right for you.