Target Date Funds: Is Convenience Worth the Cost?

by Darwin on June 18, 2012

Target date mutual funds seek to make retirement planning as easy as ever. Simply pick a date and a contribution level to let the target date fund manager do the rest for you.

The goal for any fund company is to become a “one stop shop” for their clients. A target date fund gives much broader diversification than your average mutual fund.

How Target Date Funds Work

Target date funds are generally funds of funds, meaning the fund invests in other mutual funds and exchange-traded funds. The fund’s specific holdings are adjusted based on the amount of time to retirement. The portfolio is automatically rebalanced to keep within commonly-accepted diversification and asset allocation levels.

As the length of time before retirement goes up, so does the percentage of assets in more volatile asset classes like stocks. As the time to retirement goes down, fixed-income products like bonds make up more of the fund.

Lifecycle Fund Riskiness

In general, I think target date and lifecycle funds result in better outcomes for ordinary investors who have limited understanding of asset allocation. Most people know when they want to retire, and I would assume a majority understand that it will be in their late 50s at best, and on average, in their 60s.

But there is still a difference in opinion when it comes to asset allocation. For example, iShares S&P Target Date 2035 (TZO) holds 55% of its portfolio in US stock, 25% in international stock, and 15.65% in bonds. American Funds Target Date 2035 holds 53% of its assets in US stock, 30% in international stock, and roughly 9% in bonds.

See the differences in exposure? This is a hot topic in the world of retirement planning. There are literally hundreds of target date funds, and several for each different retirement date. The problem is that every manager seems to have a differing opinion about how you should allocate your retirement portfolio to retire by a specific date.

Making the Most of Asset Allocation Decisions

Target date funds are best for people who have a very long time to retirement. Those who are younger than 35 arguably derive more value from a target date fund than people who are nearing retirement. I don’t think a target date fund really creates all that much value for people closest to retirement. In fact, target date funds can be downright dangerous.

Here’s a 5-year chart of the American Century LIVESTRONG 2015 (ARFAX) fund:

target date funds

As you can see, the fund seems to have been far too aggressive in its asset allocation. Notice how the fund lost more than one-third of its value from 2007 to 2009. In 2007, someone with a target retirement date of 2015 had only eight years to retirement. The fund was very, very aggressive for someone so close to retirement. While the fund did recover, I don’t think there are many financial planners who would have been so risky with their allocation only eight years from expected retirement.

Thankfully, greater wealth tends to correlate with age. And greater wealth makes it possible to pay for individual advice.

For 20-somethings and younger 30-somethings, a target date retirement fund picked with the idea to retire on the worker’s 65th birthday is a reasonable and safe wager. As time goes on, however, investors would be better to ditch the plain-vanilla plan in a target date fund to seek individual advice.

Depending on the particular fund, the fee to hire your own financial planner is much less expensive than the long-run cost of a target date funds. Some target date funds are downright cheap – iShares’ funds have an expense ratio of .3% across the board. American Century is far more expensive, with expense ratios of more than 1% per year on its loaded funds. (American Century sales loads are massive…5.25% for the first $50,000 in invested capital.)

In short: Target date funds are great for people who would spend a greater percentage of their assets to hire a financial planner for a once-a-year review of their asset allocation. Otherwise, investors with more assets who are closer to retirement would do much better with an individualized plan. There is significant “wiggle room” in your retirement plan in your younger years, but absolutely no room for error at retirement (see more in Retirement Articles).

{ 6 comments… read them below or add one }

Roger Wohlner June 19, 2012 at 9:51 am

Good article. As an advisor to both individual investors and 401(k) plan sponsors, I have never really been a fan of Target Date Funds. I do agree they are a far better solution for younger participants than for those who are closer to retirement. The differences in allocations among funds with the same target date can be dramatic as you point out. About a year ago we changed the TDF family for one of plans I advise. In doing so we looked at the demographics of the participants, the glide paths of the families we were considering, and the typical behavior of the participants when they leave the company in terms of whether they leave their money in the plan or roll it over/take a distribution. There is a lot of analysis that should go into choosing which TDF family to offer from a plan sponsor viewpoint. For an individual investor there are also many factors including cost and how the TDF meshes with the rest of their outside investments. Lastly, I think the fund providers have done a generally poor job of explaining to investors that they don’t have to invest in the fund with the target date closest to their anticipated date of retirement. They can go closer or farther depending upon their goals and risk tolerance.


JT June 19, 2012 at 10:37 pm

You bring up a good point regarding retirement date choice. I think you’re right on the money: most people don’t understand the relationship between time and their goals, so they’re likely to pick a bad allocation because of their chosen retirement date.


Sun June 23, 2012 at 9:15 pm

My employer gave us vanguard target retirement. 0.18% expense ratio. Hard to beat that. People who think they can favorably time the market are delusional. Survivorship bias is a great example of this delusion.


Darwin June 24, 2012 at 9:40 pm

I wish my employer would go Vanguard. Frankly, I don’t understand why any company uses higher fee providers.


Roger Wohlner June 26, 2012 at 9:01 am

There can be many factors including restrictions placed on the available TDF options by the plan provider. Among the various TDF suites Vanguard is hard to beat given its low cost and straightforward approach. As a plan provider, Vanguard is not always as low cost as they might seem. I’ve done several provider searches over the years and we’ve never selected Vanguard as the top provider. That said I am a big user of Vanguard products for both my 401(k) plan and individual clients. Lastly, low cost is a great starting point, but should not be the only criteria used to make investment choices. This is one of my fears regarding the 401(k) disclosures that participants have/will be receiving this summer.


A Blinkin June 28, 2012 at 10:23 pm

I think you nailed it by saying that these funds are great for young people. Especially considering the alternative could be doing nothing.

I see a lot of young adults getting overwhelmed with the investment options available to them. The decision paralysis causes them to do nothing. Because of this, I think a simplified Target Date fund is fantastic.


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