Target date funds have become more and more popular in the past 10 years, growing at a ridiculously rapid pace (from about $10bil in 2006 to $700billion in 2015). While I think they serve a very valuable purpose for a large amount of investors there are some serious drawbacks that are often ignored by the retail investor.
What Are Target Date Funds?
Target date funds have been around for two decades or so, but their popularity has skyrocket after 2006 when they became a default investment option.
Target date funds first appeared in November 1993 when Barclay’s Global iShares introduced its LifePath Portfolio. Their market share was greatly expanded when the Pension Protection Act of 2006 specified that approved default investments must be offered inside all qualified retirement plans. Because the structure of target date funds met all of the fiduciary requirements that were laid out in this legislation, they became a vehicle of choice for many money managers. Automatic plan enrollment by many employers further increased the flow of money into these funds.
It should be noted that target date funds come in both ETFs and Mutual Fund variety and for the most part could be used interchangeably for this post.
How Target Date Funds Work
Target date funds work by providing an upfront asset allocation based on your desired retirement year (usually in 5 or 10 year increments) and then automatically gliding the allocation as the years creep up towards retirement. The fund takes care of rellocating based on the assumption that when a retiree gets closer to retirement he or she should be taking less risk. Therefore, it shifts from a percentage of the funds from supposed volatile equities to bonds and/or cash.
Comparing Two Vanguard Date Funds For Allocation Purposes
So if we take a look at the Vanguard Target Retirement 2045 Fund (VTIVX) we can see it has the following allocation:
- 89.93% Stocks
- 10.07% Bonds
As compared to the Vanguard Target Retirement 2035 Fund (VTTHX):
- 79.75% Stocks
- 20.25% Bonds
As Compared to the Vanguard Target Retirement 2015 Fund (VTXVX):
- 45.25% Stocks
- 54.75% Bonds
The idea is that as the holders of shares in the funds get deeper into retirement the fund will automatically reallocate the underlying money within the fund. So, all else being equal when we are in 2037 (i.e. 2 years after the 2035 fund hits retirement) its allocation will look like the 2015 fund as of the publishing date of this post (e.g. 2017).
How Investors May Misuse Target Date Funds
There are some inherent flaws of target date funds like selling out (gliding) based on a date while ignoring the markets, but that is not the point of this post. Rather, I want to highlight how some investors misuse the funds given to them.
Ignoring Other Assets
Let’s say you have 2 assets, your target date fund and a bond portfolio you inherited from your parents that are equally valued at $100,000 each (easy for math purposes). You think since you want to retire in 2035 so you put your target date fund allocation into the 2035 fund above. That means you have your $100,000 of bonds, PLUS $20,000 of your target date fund (20% of your $100k) in bonds leaving you with an allocation of 60% in bonds despite being in your mid 40s. Most people do not just have two accounts – so this exercise only becomes more complicated.
Ignoring Risk Tolerance
Target Date Funds, by their very nature, ignore risk tolerance. They assume your risk tolerance based solely on when you think you want to retire. This a very dangerous assumption.
Ignoring The Difference Between Allocations
Related to risk tolerance, different companies allocate within the fund differently. For example if we were to compare the Vanguard 2015 to the Trowe price 2015 we can see a difference:
- Stocks – 45.25% vs 51%
- Bonds – 54.75% vs 49%
Then if we look at the Fidelity 2015 we see yet another allocation:
- Stocks – 58.11%
- Bonds – 31.73%
- Short Term Assets (Cash) – 10.16%
Which one is safer? Which is Riskier? These are questions that an investor should know before picking one versus the other with their own risk tolerance taken into consideration.
Ignoring Glide Path
Since the underlying asset allocation is different it can only be assumed how they get to the eventual allocation has to be different. Maybe one fund manager sells out at X-Year while the other in Z-Year; and that matters!
Last, but certainly not least, are the fees, which vary wildly,
Fidelity Freedom K 2050, a target-date fund designed for investors who plan to retire in 2050, had an expense ratio of 0.67%, while other funds with the same date and similar portfolios had lower fees. BlackRock LifePath Index 2050 charged 0.45%, while Vanguard Target Retirement 2050 Fund charged 0.16%
Hell, I wish I had a 401(k) option with a .67% expense fee, but ignoring my own hatred for my investment options, how do you justify a 200%+ difference between Vanguard and Fidelity?
It becomes even more problematic when you consider that a large portion of Target Date Funds are largely just funds of funds (from the same article),
American Funds 2030 Target Date Retirement has 22 funds from the American family, which have a weighted average expense ratio of 0.39%. The target-date fund’s expense ratio is 0.73%, for a 0.34-percentage-point premium over the underlying funds
These differences could equate to tens of thousands of dollars, for someone’s retirement.
What I Can Appreciate about Target Date Funds
I know I painted a pretty dim picture of target date funds, but I actually do like them. What I dislike are the traps that a retail investor could fall victim to without proper education. What do I like about target date funds?
- It provides an easy option for someone to get exposure to the market
- At the same time they can prevent an overly aggressive investor from being too deep into equities close to their retirement, and they can force equity exposure to someone who is otherwise too timid
- They may remove an expensive advisor by automatically reallocating
None of my assets are currently in a target date fund, but I would absolutely recommend them to friends and family once I explain their possible deficiencies.
Do you own any Target Date Funds?