Articles

Pros and Cons of Target Date Funds

By Jimmy Turner, MD
The Physician Philosopher

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 TDF’s has continually increased through the years.  In fact, Vanguard has shown that 77% of participants use a target-date fund and 52% of people have their entire portfolio in a single target date fund.

While target date funds offer some tangible benefits, are they the right choice for you?  Here are several pros and cons of TDF’s to help you answer that question.

First, let’s cover some basics.

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What is a Target Date Fund?

A target date fund 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

TDF’s 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 target-date fund is very appealing. You don’t even have to look at your 401K 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

TDF’s 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 TDF’s, 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 TDF’s 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 TDF’s 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 401K. 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 403B at work.  If I relied on a target date fund inside my 403B, 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 TDF’s assume that it is your only investment and makes 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, TDF’s 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.

TPP

15 Comments

  1. Psy-FI MD

    Great pro/con view on target date funds.
    As you stated above, the key when choosing the right target date selection in your retirement plan is looking at your actual risk tolerance.

    I am currently in a target date fund and because my risk tolerance skews more conservative, I’m in the 2030 fund. I told several of my colleagues of this and they were surprised how much risk they were taking on.

    One other point is that target dates aren’t the best in a taxable account. They will contain taxable bonds.

    Regards,
    Psy-FI MD

    Reply
    • ThePhysicianPhilosopher

      Definitely good points. Target date funds are not risky enough for my taste. To each their own 🙂

      Reply
  2. Andrew Wilner, MD

    I agree with the above analysis.
    Personally, I am not that strict when it comes to rebalancing my portfolio every year regarding stocks and bonds because I don’t know what the best balance is anyway! So I have more tolerance than many investors for a little “drift” of the balance without stressing out.
    I use a target-based fund as a large part of my portfolio, then mess around (oh, sorry, “perform careful analysis”) with the rest. That gives me the security that I have a core “strategy” that works, and I explore other options that may or may not be better with whatever’s left over.

    Reply
    • ThePhysicianPhilosopher

      Only with a perfect prospectiscope can we know what the best asset allocation is… I only rebalance once each year, but going two or three would probably be fine.

      Reply
  3. FiPhysician

    Why would you want less international exposure?

    Reply
    • Dr PayItBack

      Concerns over long-term performance of an asset class that depends on the economies of countries with more lax regulation and intellectual property protection.

      I don’t share a ton of those concerns, I hold 20% international equity, but I get it. Fact is none of us know. More important than the actual allocation is the rebalancing that occurs in the long run (and not performance-chasing).

      Reply
    • ThePhysicianPhilosopher

      With the global markets being ever more interconnected, I am not sure that it will provide a ton of benefit. I do have some expsoure, but certainly don’t want more than 20% in my portfolio. This is different for everyone, obviously, but is one reason I don’t use a Target Date Fund where the exposure is much higher.

      Reply
  4. KK

    I’ve been wondering about transferring some funds out of target date fund to make tax loss harvesting more effective (not 401k obviously- but after tax contributions) . Does this make sense? I would assume as the fund rebalances itself it does this somehow on its own but also seems like it might be a setup for the fund to be forced to buy high and sell low?

    Reply
    • ThePhysicianPhilosopher

      If the fund automatically purchases back into the same funds within a certain period of time any Tax Loss Harvesting opportunities will be lost because of wash-sales. This is likely not the best way to do that and, in fact, is one reason you should not automatically reinvest dividends in a taxable account where you TLH.

      Reply
  5. Dr PayItBack

    I don’t hold target dates mostly because of con #4. I trust myself to rebalance unemotionally, and I don’t mind devoting a few minutes a quarter or whatever to that, so target dates just aren’t worth it to me.

    Reply
  6. BSM

    We used a target date fund for the first few years of saving for retirement. I totally understand why many folks recommend using these. But not TDFs all are equal! After educating ourselves and developing an IPS, we really discovered several issues with ours. Overexposure w/ small cap and international. High expense ratio. Limited “space” for investing (we were only using it for our Roths if I remember correctly). It obviously requires more time to calculate asset allocation percentages each year with multiple mutual funds/ETFs, but I think the extra time is worth it.

    Reply
  7. dan

    Great list of pros and cons! My personal barrier for using them for myself is that they are too conservative at nearly every timeframe, in my opinion. I just believe they are too high in bonds. And I also feel they tend to be > international than I would like. But, I definitely think they’re a great addition to the industry for everyone who doesn’t have the desire to learn more about investing. For those folks this is the best-case scenario. Super simple, accessible, and easy enough to understand and hopefully stick with!

    Reply
  8. Eric

    One pro you did not mention is that the TDFs provide a liability shield against fiduciary complaints. I manage the defined benefit plan for my wife’s employees, and I do a weight based single allocation to a TDF targeting age 65 retirement. You can argue, looking at 2008, that TDFs are way too stock heavy for many conservative investors (ie the ave person), who can’t risk a 30% drop early in retirement (See Bodie & Taqqu “Risk Less & Prosper More”) But in my situation, it definitely makes life easier, without hiring another fiduciary to do the work.
    Not sure but a balanced fund probably provides a similar shield.

    Reply

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