First, let me give this disclaimer: Target Date Funds are a great solution if the alternative is leaving your retirement money in a Money Market Fund. That said, there are three problems with almost all Target Date Funds inside of employer sponsored retirement accounts (like 401k and 403b plans).
What is a Target Date Fund?
Target Date Funds were meant to it simple to invest for a specific date in the future – like the year you retire. In theory, an investor can select the Target Date Fund with the year closest to when they are planning/hoping to retire. For example, a 35 year old planning to retire at age 60 might select a 2040 Target Date Fund. This single fund election is comprised of a few individual Mutual Funds to give instant diversification across asset categories: Large Company Stocks, Small Company Stocks, International Stocks, Bonds, Money Market, etc. Target Date Funds automatically adjust the risk profile of the fund (the weighting of stocks vs. bonds) inside the portfolio as the years progress. So, a 2040 Target Date Fund may have 80-90% of the portfolio in stocks, but by 2039 it will likely have adjusted the ratio closer to 50% stocks and 50% bonds/money market. This happens automatically for the investor, without them doing anything on their own. In theory, it seems fairly intuitive and a decent strategy for retirement saving. Now let’s discuss the shortcomings.
1. Too conservative
The primary problem with most Target Date Funds is that they are too conservative. They are built in a way that covers the fund company’s liability, but does not necessarily operate in the best interest of the investor clients. The three largest distributors of Target Date Funds are Fidelity, Vanguard, and T. Rowe Price. While each company has its own take on the composition of their Target Date Funds, they all lean towards being too conservative for investor’s time horizon. Let me explain. The average age of our blooom client today is 39. If they settle for a Target Date Fund with a date that matches their planned retirement date, it would likely be one with a 20+ year time horizon (a 2035-2045 Target Date Fund). Dissecting the underlying holdings of a 2035 Target Date Fund from Fidelity, Vanguard or T. Rowe Price, it’s shocking to see how much is invested in bonds and money market – often as much as 20%. That is too conservative. Bonds and money markets are two asset classes that are likely to earn their investors close to zero on a real return basis over the next several decades. The “safety” of bonds and cash is better utilized for retirement savers nearing the finish line. For people in their 20s, 30s or 40s, with decades to grow their nest egg, this allocation could drastically reduce the growth of their portfolio over time. Not good! At blooom, we tend to recommend a higher allocation of stocks over bonds for our younger clients. Of course, they can modify our recommendation. But we believe that we should be giving our best advice to our clients, not the advice that merely covers our rear ends!
2. High expense ratios
The second problem, Target Date Funds can be a costly investment (Vanguard being an exception to this rule). For example, in one of the larger 401k Platforms, the Principal LifeTime 2040 Fund has an internal expense ratio of 1.14%, which is almost five times as expensive as an individual index fund. The portfolio algorithm that is in place for blooom clients automatically selects the fund option in each asset class within our clients’ 401k or 403b with the LOWEST possible internal expense. So, if your plan offers a decent menu of index fund options, it is often the case that our clients’ custom built blooom allocations have a lower overall operating expense than the Target Date Funds being offered.
3. Lacking personalization
Finally, at blooom, you don’t have to settle for one-size-fits-all investment options like Target Date Funds. Prior to blooom, I managed portfolios for high net worth investors, which we customized using low cost mutual funds and index funds. One of the main reasons we started blooom was to deliver the same professional investment advice to someone putting their first $100 into their account, as someone with over $1 million knocking on the door of retirement. You shouldn’t have to “qualify” by having a huge portfolio to get this level of portfolio management. With technology, we can and will continue to make this available to anyone with a retirement account, regardless of where they work, where their account is held, or most importantly…the size of their account.
You deserve better – don’t settle for mediocrity, especially when it comes to your retirement nest egg.
Published on November 11, 2015