My first encounter with a Target Date Fund was back in 2006 when my company made Vanguard Target Retirement Funds available for our 401(k) plan. I evaluated the option of using a Target Date Fund but decided against using it because I prefer to manage asset allocation myself using the more traditional asset class-based funds. However, I think Target Date Fund is an excellent option for 401(k) plans in general because it is a less intimidating way to present investment options to participants and will probably encourage a higher investment rate overall.
What are Target Date Funds?
A Target Date Fund, or Target Retirement Fund, is a mutual fund designed with a specific retirement year in mind. For example, if you are 20 years from retirement, and this is 2019, you’d pick a fund with the target year of 2019 + 20 = 2039. Since they are usually offered in 5 years increment, a 2040 Target Retirement Fund is the option you’d consider.
As the fund approaches the target retirement year, the fund asset allocation becomes more conservative — investing in more fixed-income investments — to decrease risks and preserve capital.
Here’s Vanguard 2020 versus 2040. This comparison illustrates how the fund changes over time:
Vanguard Target Retirement 2020 (VTWNX)
Vanguard Target Retirement 2040 (VFORX)
As you can see, Vanguard 2020 is more conservative with a 46.85% allocation to Bonds versus 15.88% for Vanguard 2040. As time progress, Vanguard 2040 will slowly increase its Bonds position.
Target Date Funds Advantages (Pros)
I think three things make Target Date Funds attractive.
1. Easy to Understand and Start
Target Date Fund is one of those “buy it and forget it” investments. You just have to figure out when you want to retire and buy the fund with the closest retirement date. As you invest more money into your 401(k), you’ll automatically add to your position without having to worry about asset allocation and regularly rebalancing your portfolio. This is perfect for people who are afraid to get started with investing.
2. Instant Diversification
Target Date Funds help you automatically diversify between the two most important asset classes — equity and fixed-income. Additionally, Target Date Funds are what The Street calls Funds of Funds. This means they invest in other mutual funds, making them a very diversified investment.
For example, Vanguard 2040 consists of the following funds (data as of July 2019):
| Fund | Allocation | Expense Ratio |
|---|---|---|
| Vanguard Total Stock Mkt Idx Inv (VTSMX) | 50.30% | 0.14% |
| Vanguard Total Intl Stock Index Inv (VGTSX) | 30.48% | 0.17% |
| Vanguard Total Bond Market II Idx Inv (VTBIX) | 11.45% | 0.09% |
| Vanguard Total Intl Bd Idx Investor (VTIBX) | 4.74% | 0.13% |
3. Less Expensive for Businesses
This benefit might not be evident to individual investors, but as a business owner, I had the opportunity to set up a Solo 401(k) account with Vanguard. One of the things I have to decide on was what investments I would like to have available in the plan. The only problem was that it would cost $20 per year for each Vanguard fund held in the 401(k) account.
To save money on administrative fees, I opted to have only one fund — you guessed it, a Vanguard Target Retirement Fund.
Target Date Funds Disadvantages (Cons)
There are also a few things that make Target Date Funds unattractive:
1. Double Fee Structure
Target Date Funds are Funds of Funds. For some funds, you are paying for both the fund’s direct expense and indirectly for all of the underlying funds’ fees as well.
Note: Vanguard is an exception to this rule. The 0.14% expense ratio is the total expense you pay.
2. Skewing
You could accidentally hurt your portfolio when you own a Target Date Fund plus other investments because the fund already optimizes its asset allocation for a specific retirement year. For example, if you have more equity investments in addition to a Target Date Fund, your overall portfolio is more aggressive. On the other hand, owning fixed-income investments would do the opposite to your portfolio, skewing it the conservative side.
3. Hard to Evaluate
Because of the two layers structure, they are harder to evaluate than a traditional fund. Secondly, it’s hard to compare them to an index like the S&P 500 because they are diversified, including both equity and fixed-income investments.
4. Same Date, Different Allocation
You might have a false sense of security because the fund is targeting a specific date that you’re getting the most optimized asset mix for that retirement date. Here is an excellent example using two of the most popular Target Date Funds:
- Vanguard Target Retirement 2040 Fund’s Objective: Seeks to provide capital appreciation and current income consistent with its current asset allocation. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund.
- Fidelity Freedom® 2040 Fund’s Objective – Seeks high total return until its target retirement date. Thereafter, the fund’s objective will be to seek high current income and, as a secondary objective, capital appreciation.
So they both have a fairly similar objective, now let’s see what an optimized asset allocation for 2040 looks like (data as of July 2019):
| Vanguard (VFORX) | Fidelity (FFFFX) | |
| US Stocks | 49.80% | 66.46% |
| International Stocks | 33.40% | 31.48% |
| Bonds | 16.80% | 8.06% |
That’s a huge difference!
In summary, it is hard to compare Target Date Funds from different companies like Vanguard and Fidelity without spending time digging into each fund. In other words, a 2040 fund from one company could be very different from a 2040 fund from another.
5. One Size Fits All
It’s nice to be able to pick the “most optimal” fund just by looking at the retirement year. However, it is essential to realize that these funds do not take your individual financial goals or risk tolerance level into account.
That said, you can usually find ways to personalize your portfolio a bit.
For example, you can buy a 2050 fund (instead of 2040) if you want to invest more aggressively to increase your “expected” return. Alternatively, you can achieve a similar result by keeping the 2040 fund and add more Stocks exposure to your portfolio.
6. Not The Most Tax-Efficient Option
For tax purpose, there are several shortfalls with Target Date Funds.
First, these funds are not optimized for all account types. In general,
- Roth – You want your most aggressive growth investments to be in Roth account for the long-term tax-free growth.
- Tax-Deferred Account – Your income-generating investments should be your tax-deferred account so you don’t have to pay income taxes on the dividends and distributions each year.
- Taxable Account – Probably the best place for your higher-risk investments so that you can claim tax loss and be able to replenish the account.
Second, you cannot do tax-loss harvesting if one of the asset class goes down. For example, let’s say international stocks took a hit, you can’t sell a portion of your Target Date Fund to capture the loss.
Third, when you donate shares of a highly appreciated stock, you get to claim tax-deduction on the donation plus you don’t have to pay capital gains tax on the appreciation. You lose this option with a Target Date Fund.
Other Considerations When Buying Target Date Funds
There are also a few other things you may want to consider when investing in Target Date Funds.
1. Your Existing Portfolio
As mentioned before, owning other investments in addition to a Target Date Fund can work against you due to skewing. This means that if you want to get into a Target Date Fund, you may have to consider liquidating your existing portfolio. At the very least, be very careful with its asset allocation. Portfolio liquidation can be a problem for investors who have accumulated a large number of assets. Trading costs and potential tax consequences (especially for investments in taxable accounts) can erode returns and cause financial strain.
2. Actively Managed Fund
Some Target Date Funds are actively managed. As such, there’s the potential that your fund manager may stray from the stated investment policy. For example, he or she may be investing more aggressively than stated to outperform other Target Retirement Funds. This is especially worrisome for investors who are near their retirements.
Note: this is not the case with Vanguard Target Date Funds, which are made up of index funds.
Bottom Line
I didn’t use a Target Date Fund when it was made available in my 401(k) account, but I did end up using it in my Solo 401(k) because it is more cost-effective. However, I think Target Date Funds are suitable for people who don’t want to bother managing the portfolio on their own. There is also a percentage of people who add money to 401(k) without investing the money correctly; a Target Date Fund is an excellent solution in these cases.
What are your thoughts on Target Date Funds? Do you invest in them? What do you like or dislike about them?
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Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
You are right to stay away. Target date funds are one of the biggest ripoffs in the industry. Sure, they make it easy for the uneducated investor, but at what price. I’ve seen target date funds with expense ratios over 2%. Top that with minimal performance and you have the epitome of a “lemon”. Great article. Hope many readers find it.
Another reason not to use target date retirement funds is if you do not subscribe to the theory that the best asset allocation strategy requires a gradual transition from equities to bonds and cash purely as a function of age. I for one do not think that is the best strategy to provide a stable standard of living in the pre- and post-retirement phases.
I’m currently investing in a TRF: Schwab Plan Retirement Trust 2040. Have been for about a year now. Expense ratio is .54 of fund assets. But I don’t see any “funds within funds” expense. Can someone please show me what that is? And how come I never see these expenses on my statement?
Investing education is a hurdle I’ll admit that I need to get over, but it’s frustrating when you can’t see things clearly, b/c investment firms make it difficult.
Great job on this! More and more people are investing in these in their 401(k) because they are easy. Although this may not be the best move, at least they are not leaving it in the default money market account. I also like the fact that many 401(k)s are making these target-date funds the new default fund. It will help out individuals who would otherwise leave their money in the money market account due to lack of education. Which is something else companies have to work on: educating their employees.
With Vanguard, your 0.21% expense ratio is all you pay.
Another reason that Vanguard is simply the best investment company out there.
Plus gradually shifting from stocks to bonds without having to do much portfolio tweaking is an attractive option to many (myself included).
Also, at least with Vanguard, you get a little bit of instant diversification when you first start (stocks/int’l stocks/bonds in the mix).
Another good reason to use Target Retirement Funds is that you need a substantial portfolio value to properly allocate and diversify. The minimum to get into a Vanguard TRF is $3000. But the minimum to buy into all of those funds separately is $15,000 — and that just gives you equal ownership in those 5 funds. You’d need $82,000 to assemble the same portfolio outside of the TRF.
So TRFs are a great way to get started as an investor, and once a large enough portfolio is built, one can start to customize.
The below seems to indicate Vanguard doesn’t double-charge. “Although the Fund is not expected to incur any net expenses directly, the Fund’s shareholders indirectly bear the expenses of the underlying Vanguard funds (the Acquired Funds) in which the Fund invests. These expenses, along with the transaction costs (i.e., purchase and redemption fees), if any, imposed on the Fund by the Acquired Funds, are reflected below in the line item for “Acquired Fund Fees and Expenses.” However, they also indicated with fine print under “Annual Fund Operating Expenses” “the Total Annual Fund Operating Expenses shown in this table do not correlate… Read more »
It appears that Fidelity matches the practice referenced above at Vanguard. Look at its prospectus for the Fidelity Freedom 2030 retirement fund (or any of the others). They charge no management nor 12b-1 fees, but do pass through the expense ratio of the underlying funds. Further, http://www.investopedia.com/terms/a/acquiredfundfeesandexpenses.asp#axzz1d3sPznbV says it’s now a requirement to name the double-dipping fees if any: “What Does Acquired Fund Fees And Expenses – AFFE Mean? A line item in a fund-of-funds’ prospectus that shows the operating expenses of the underlying funds. This became a requirement as of January 2007 and this information is found beneath the… Read more »
I currently manage my own portfolio using the same funds as the Target Ret. Funds, but am considering switching to the Target Ret. 2020 for our IRAs for one reason: my wife is not as financially savy as I am, and if I die before she does, this would make things a whole lot easier for her. I would not use TR20 in our taxable account, however, as I prefer to use munis for the bond portion here. Only one thing I don’t like about The TR Funds: they’re a little light on mid/small caps. I currently hold a percentage… Read more »
I have been considering the Asset Management service at Vanguard because I am 87 and preparing for my eventual demise and transfer to my 67 year old wife, who is not very financially savvy.Suddenly, the idea of getting into their 2010 Retirement fund instead, without the 0.7% management fee, and similar diversification looks very appealing. Any comments?
I’m still trying to figure out where/how to invest after retirement. Does a target fund still work after the retirement date? I have less than two years to go.
I am retiring in a few months and am considering “bucket strategizing” within the Vanguard Target accounts. For example 30% in 2015, 30% in 2020 and 30% in 2025 etc and withdraw approx 4% from each for my living expenses. My thought would be that I would be covered for market ups and downs. Any thoughts/critcisms?
The use of “units” as value variables, really makes for some sneaky accounting and fee collection.
Anyone offering a Vanguard Target Retirement Fund is themselves making money off of selling it, and companies are pouring their employee’s retirement accounts into it without those employees knowing anything about it. Sign here, they say.