Are Target-Date Retirement Funds the Best Choice?
Source: DFA Matrix Book 2019
Most People Don’t Choose Their Investments
The main investing opportunity for the majority of people is a retirement account offered through their employer, like a 401(k).
And yet, most people can't even tell me what their investments are inside their 401(k). They don't know.
I think the main reason for this is when you're starting a new job, you're in a state of life transition.
There's a lot going on. You're getting used to new people, a new routine, new responsibilities, sometimes a new place to live.
Things are kind of crazy. So when you're filling out all your "new employee" paperwork, you just check the little box that says "choose 401(k) investments for me", instead of researching your fund options and being deliberate about what you're doing.
And what will you usually have selected for you? A target-date retirement fund (or just “target date fund”).
Target Date Funds
Target date funds basically anticipate your assumed retirement year based on when you'll hit age 65, and then stick you in a fund with that year's name on it. They're usually offered in increments of 5 years.
So, if you're 35-years old, you'd be 65 in 30 years (2049-ish), so you'd get put into a 2050 Target-Date Retirement fund.
These funds a great choice for you if you don't know what you're doing. They'll put you in a broadly diversified portfolio with a higher allocation to stocks when you're young, and slowly shift more money towards bonds as you get older.
Again, they work for someone who otherwise doesn’t know what to do.
But there is a lot of room for improvement. You can do much better than a Target Date Fund.
I’m going to point out the three main problems of Target Date Retirement funds that clearly show why they’re not the best choice.
Problem #1: Target Date Funds Don’t Allocate Much to the Best Performing Asset Classes
It's clear that over long periods of time, certain asset classes have outperformed others.
As you can see, small-cap stocks are at the top of the list.
As of Oct. 2019
The chart above clearly shows that small cap stocks are the number #1 performing asset class.
So how much do Target Date funds allocate to small cap?
Here are four of the biggest Target Date Retirement mutual funds used nationally in 401(k) plans (I’m going to use the 2050 class, though they exist for every 5-year interval):
Vanguard Target Retirement 2050 (VFIFX)
Fidelity Freedom 2050 (FFFHX)
American Funds 2050 Target Date Retirement R6 (RFITX)
T. Rowe Price Retirement 2050 (TRRMX)
Because each of these target date funds are built for someone who is about 35 years old, they're all heavily weighted toward equities: between 84-88% stocks, 12-16% bonds.
So let’s see what the small-cap exposure is in these funds:
As of Oct. 2019
This is how much each of the four different target date funds above are currently allocating to small cap stocks:
Vanguard: 3.43%
Fidelity: 3.79%
American Funds: 1.40%
T. Rowe Price: 3.50%
That's it. All these funds allocate less than 3.80% to the highest performing asset class.
Seems a little low, doesn't it?
And guess what? They will allocate even less to small cap stocks as time goes on, because that's what target date funds do. They lower your exposure to stocks over time in scheduled intervals, sometimes as frequently as every year.
The same goes for their exposure to real estate, emerging markets, or value stocks. Most target date funds allocate very small amounts to each. They are important asset classes for diversification and higher potential returns.
Problem #2: Target Date Funds Have High Fees
The easiest way to reference the annual fees you’ll pay on a mutual fund or exchange-traded fund (ETF) is its expense ratio.
An expense ratio is expressed as a percentage of your balance that you’ll pay as a fee on an annual basis.
If you have $100,000 in a target date fund with a 0.50% expense ratio, your annual fees will be $500.
For reference, I think most of the funds you use in your portfolio should be 0.25% or less, and you should be able to keep your entire portfolio’s expense ratio to less than 0.40%.
What are the fees for the “9 Best Target-Date Retirement Funds”, according to this arbitrarily chosen review from U.S. News & World Report? (It does represent some of the most well-known and used target date funds)?
Here they are, from most expensive to least expensive:
American Century One Choice 2055 Inv (AREVX): 0.92%
JPMorgan SmartRetirement® 2050 A (JTSAX): 0.88%
MFS Lifetime 2050 A (MFFSX): 0.86%
USAA Target Retirement 2050 (URFFX): 0.83%
Fidelity Freedom® 2050 (FFFHX): 0.75%
T. Rowe Price Retirement 2050 (TRRMX): 0.71%
TIAA-CREF Lifecycle 2050 Retirement (TLFRX): 0.70%
American Funds 2050 Trgt Date Retire R6 (RFITX): 0.41%
Vanguard Target Retirement 2050 Inv (VFIFX): 0.15%
These are nine of the biggest target date funds out there. And only two of them have an expense ratio at or below a preferred level!
If you are sitting here thinking that this difference in fees an expense ratios really seems like a big deal, you’re not grasping the concept. Check out “The Trust Cost of a 1% Expense Ratio” by Betterment.
If you want to have tens, maybe hundreds of thousands of dollars less than you could over your lifetime, then go ahead and ignore this problem with your target date fund. But if you want to have more wealth, learn to appreciate the significance of fees and expense ratios.
Problem #3: Target Date Funds Are Too Conservative
The final problem I’ll go over is how Target Date Funds run their stocks-to-bonds allocation over time.
Basically, there’s a general idea in investing that the younger you are, the more years you have until retirement. So, you have the “risk capacity” to have a high allocation of stocks - which are more volatile than bonds - in your portfolio.
In theory, this is the assumption that you’re not going to care if there’s a 20% drop in your retirement account today because maybe you’re not retiring for 15, 20, or even 30+ years.
But as you get closer to retirement, you’re assumed to want less risk and volatility in your portfolio. Thus you’ll pare down your stock allocation over time and increase your allocation to bonds.
This gradual shift from more stocks and less bonds to less stocks and more bonds is called a glide path.
Here’s a quick video of me describing what a glide path illustration looks like. This is for the Vanguard Target Retirement 2050 Fund (VFIFX).
Source: Vanguard
The “set it and forget it” nature of an automatic glide path does accomplish something similar to what most people would want to do over their lifespan.
However, where the criticism lies is that the glide path is too conservative. I believe this is often the case for many target date funds, as do many other financial professionals and experts.
By this, I mean that it lowers your allocation to stocks too quickly and ends with too little stocks at retirement for what many people need. Since stocks are the main driver of your investment returns over time, this results in less wealth built up and sustained over your life.
The best course of action is to make a comprehensive financial plan (with or without an advisor) where you create and follow your own glide path based on your goals, how much you’re saving, how much you have in assets, etc.
Conclusion on Target Date Funds
So there you go. The three main weaknesses of Target Date Funds:
Low Allocation to High Performing Asset Classes
High Fees
Overly Conservative Asset Allocation and Glide Path
Here’s what I want you to consider:
If you have had very little involvement in choosing what's in your 401(k), or if you've just put your money into a target date fund, then you are not optimally invested.
You're missing out on a more ideal way to invest, because you've made the mistake of using a Target Date Retirement Fund.
