Should You Invest in Target Date Funds for Retirement?
Should you Invest in Target Date Funds for Retirement?
Target Date Funds are all the rage in modern 401(k)s, IRAs, and even brokerage accounts where eventual retirees feel empowered to make their own financial decisions.
The simplicity of identifying a year you expect to be retired and ‘setting it and forgetting it,’ is tempting for many and as such the industry has exploded in growth. For many, Target Date Funds represent an alternative to paying for a Financial Advisor. They find it a cheaper way to get portfolio diversification, automatic rebalancing, and the appropriate amount of risk even as the target date approaches.
But is investing in a Target Date Fund for retirement a good idea? What are the pros and cons? Are there any recommendations for selecting a Target Date? And finally, what happens after the Target Date? I’ll go over all these topics and more in this article.
In this Article
What are Target Date Funds?
Very simply: when you select a Target Date fund you are roughly identifying the year you plan on retiring and buying a fund that changes the risk profile of its holdings periodically to match your retirement goal
For example, if you select a fund with the year 2060 in the fund name then you are picking a fund that is targeting this year for its most conservative investments. However, its current holdings are likely much more aggressive.
In a 2060 fund you could expect almost 40 years to go buy before needing the money invested and thus higher risk investments are selected such as equities and foreign funds. As you get closer to the year 2060 the fund will likely start to move investments towards bonds thus lowering the risk of loss.
All of this is done automatically.
When you choose a Target Date Fund what you are opting for is convenience. You won’t have to think about the specific portfolio composition. You won’t have to rebalance the assets. You won’t have to think about how much risk you are taking on and if it is appropriate for your expected retirement timeline.
Target Date Funds Quick Facts
- 2 Types of Funds – ‘To’ and ‘Through’ – If a fund is ‘to’ a certain year then its most conservative allocation will occur in the year of the fund’s name.
If a fund is a ‘through’ a certain year, then it will consider that you will likely want to still have an elevated risk profile during the first years of retirement to ensure you have adequate returns through the end of retirement. The most conservative allocation will not occur until after the Target Year but will still prioritize the year as when you will retire.
- 2 Types of Funds – ‘To’ and ‘Through’ – If a fund is ‘to’ a certain year then its most conservative allocation will occur in the year of the fund’s name.
- Not All Target Date Funds are Equal – As mentioned above, the industry for these products has rapidly expanded relatively recently. Not all these products are the same and different funds may have different performance, fees, and even mechanisms to adjust for risk. Understanding the differences between funds with the same Target Year is an important research journey that you will need to undertake. Start with reading the prospectus of all the funds you are consider.
- Choosing a Target Fund over other Investments does not mean you can’t or won’t lose a lot of money – Keep in mind, no one knows the future. If you would have selected a Target Date Fund and shortly prior to retirement a 2008 style banking sector collapse occurred, the chances that you would have been retiring on time would have been slim. There are always risks to any investments and that includes these funds.
- Once you reach the Target Date, you may still not have enough to retire – The funds give you the ability to set and forget the portfolio construction… the earning and saving money part of the equation is still in your hands. Monitoring your investments over time and understanding how much you will need to withdraw during retirement and for how long is still something that you will need to keep tabs on. The target year only references how the portfolio is managing risk, not whether you can head to the Bahamas.
Typical Fees for Target Date Funds
Choosing a good fund with low expenses seems like a no-brainer. But most people will be investing their hard earned money in their 401(k) accounts. The ability to choose a specific company or fund is exceptionally limited. Fees for popular funds may be substantially higher in 401(k)’s than if you were to open a brokerage account on your own.
According to the Wall Street Journal, the average expense ratio for a Target Date Fund is 0.55%. Vanguard, just about the cheapest quality company that offers Target Date Funds, has numerous funds that are less than 0.20%… many below 0.10%.
Any fund north of 0.75% or 1.00% is approaching an egregious level of fees. If you are investing in your own account, you can do better.
If you are stuck with options that your company has selected in your 401(k) you should consider contacting your HR department. Your company can pay to have those fees reduced and / or they can shop around for another retirement account servicer.
Popular Target Date Funds Providers
Below are the best Target Date Funds as ranked by Morningstar. Most of the big brokerage houses have their own products, however if they are packaged and sold by your 401(k) provider the fees may be different from what they are advertising. These links and provided facts should only be considered outside of a 401(k). Otherwise, you will need to look at the documentation provided by the company servicing your 401(k) or your HR department.
Target Date Funds Pros
- Decisions and Interaction are Limited – Often, investors lose money by making too many trades at the wrong times. They buy high and sell low. They accidentally incur tax penalties and unnecessary fees. Target Date funds get you past all these obstacles. The only decisions that are necessary occur right at the beginning.
- Low or No Maintenance – Generally, diversified portfolios need some type of rebalancing at least annually. This can be difficult for some to execute given that they may forget or not be used to the trading platform after not interacting with it for long periods. Target Date Funds don’t need to be rebalanced by the investor… they automatically are balanced according to the time left prior to the fund date.
- Decisions and Interaction are Limited – Often, investors lose money by making too many trades at the wrong times. They buy high and sell low. They accidentally incur tax penalties and unnecessary fees. Target Date funds get you past all these obstacles. The only decisions that are necessary occur right at the beginning.
Target Date Funds Cons
- Lack of Flexibility – The ability to choose anything about a specific fund is limited to literally when and how much of the fund you purchase or sell. There is no ability to change the risk exposure of a fund without moving to an entirely new fund.
- More Expensive than DIY Approach – At the end of the day, target date funds are just a fund of funds. This means that there may be layers of expenses wrapped up in hard to analyze positions. While this is not necessarily an issue for the best of funds, it may crop up as unreconcilable in many 401(k)s that only have expensive options available.
- Lack of Flexibility – The ability to choose anything about a specific fund is limited to literally when and how much of the fund you purchase or sell. There is no ability to change the risk exposure of a fund without moving to an entirely new fund.
Target Date Fund Resources
Below is a short list of resources for more education surrounding the topic of these funds:
- FINRA’s Explanation of Target Date Funds – The Financial Industry Regulatory Authority is a government sponsored organization that aims to protect the consumers and investors. Information provided by FINRA should held to a high level and is good source of information when you need to verify so-called facts presented by your broker.
- U.S. Securities and Exchange Commission – This quick primer on Target Date Retirement Funds gives an informative and graphical way to think about how these funds work.
- 3 Best Target Date Funds by Rob Berger – This YouTube video was recently recorded by Rob Berger. If you haven’t seen his channel, then I highly recommend you take a look. His analysis is very fair and without incentive.
- FINRA’s Explanation of Target Date Funds – The Financial Industry Regulatory Authority is a government sponsored organization that aims to protect the consumers and investors. Information provided by FINRA should held to a high level and is good source of information when you need to verify so-called facts presented by your broker.
A Word of Caution
No part of this article should be considered investment advice. You should do your own research and in so doing, hire a professional that has your interests at heart (fiduciary). The topics expressed are solely my opinion, however, I presented the information honestly… the risks involved with any investment may result in the complete loss of capital so be careful.
What we Covered
In summary, Target Date Funds come in several flavors and can help you manage your risk all the way to a target year or through a target year. If you are cautious about fees and the investment vehicle you are using (401k, IRA, Taxable Brokerage) offers such products, you may be able to find a well-managed fund that changes its risk profile as you get closer to your retirement year that meets your retirement needs.
However, if you are looking for flexibility, customization, or the ability to change the risk profile casually then these funds are not for you. That said, they can be an excellent option in lieu of hiring a financial advisor or spending too much time learning about investing.
