When it comes to financial planning and investing, there are a lot of options and strategies out there. One option that has grown in popularity as an investment strategy are target date funds.
But what exactly are target date funds?
Are they a good option for me?
Are there other investment strategies I should use instead?
Below I detail what you need to know about target date funds, pros and cons, and if, in my opinion, you should use them.
What Is a Target Date Fund?
A target date fund is a mutual fund designed to invest in a mix of stocks, bonds, and cash that is ‘appropriate’ for a person investing until a specific year. Its also a type of robo-advisor because ‘automates’ the investment decisions for you and the portfolio manager.
The fund automatically rebalances its asset allocation over time to become more conservative as the target date (usually retirement) approaches.
That means the portfolio would start out with a higher percentage of stocks and shift toward bonds as you get closer to age 65. The specific mix of investments would depend on the particular fund, but generally speaking, these types of funds aim to provide growth during your working years followed by stability and income during retirement.
For example, if you plan to retire in 2045, you might invest in a target date fund that has a ‘target date’ of 2045. Today, it may have 80% allocated to stocks and 20% to bonds. However, by the time 2045 rolls around, the allocation may be 30% stocks and 70% bonds.
The primary objective of target date funds is that investors will be able to achieve their long-term goals without having to actively manage their portfolios.
Pros And Cons Of Target Date Funds
There are many pros and cons of target date funds. We’ll start with the pros and then highlight the cons.
Pros
Target date funds rose in popularity because of their advantages. Actually, they rose in popularity because of financial service firms ability to lobby congress but that story is detailed in the 401k section below.
For now, here are the pros of target date funds:
- Automatically diversified for you, i.e. you don’t have to pick the investments;
- They are convenient, i.e. instead of spending hours rebalancing and picking stocks its “set it and forget it”; and
- Some say there is less emotion because its only one investment instead of worrying about multiple investments.
Cons
The disadvantages of target date funds is so important to understand, I’m going to provide details into each below.
One Size Fits All
There is irony in the financial planning and investing world.
You see, if you went to a licensed individual such as a CFA or CFP, we would have to judge your ability and willingness to take risk before investing your money.
In fact, one thing regulatory audits look at is if your clients have the same investments or not. For example, if all your clients have x% in stocks and y% in bonds, then you are not customizing your investment advise and would face penalties.
Somehow that isn’t the case for target date funds. In fact, most do little to no analysis of your ability or willingness to take risk. Most do not even ask if you’re married or not which managing your money as a couple is a huge deal.
Instead, they use a basic academic theory stating younger people can take more risk than older people. Therefore, younger people should have a greater allocation to stocks.
Thus, if you went to all your work colleagues that were the same age and you compared your target date fund investments, most if not all would be exactly the same!
This cookie cutter approach ignores everything else about you such as your willingness to take risk, how much debt you have, family situation, your educational background, etc… All these things factor into your ability to take risk and are completely ignored by target date funds.
These factor are extremely important which is why we make people build their FitBUX profile before using our hybrid robo-advisor. We at FitBUX need this information to allocate your funds correctly.
Two More Disadvantages
Target date funds do not guarantee against losses. In fact, you are never guaranteed against losses when you invest.
However, this is important to understand because of the disadvantage we discussed previously.
Remember, target date funds do a horrible job analyzing your ability and willingness to take risk. Therefore, what I’ve noticed over the past 15 years is that people that use target date funds are taking way more risk than they are comfortable with or have the ability to take.
The more risk you take the more the investment can return but the more it can drop as well.
The drop is the important part to focus on here. When you take more risk than you ability dictates and the market tanks like it is right now during 2022, people panic.
They then move their investments into something extremely conservative which also most likely doesn’t fit your ability to take risk.
Whereas, had they been properly invested to begin with, yes the account might go down but not by an amount that makes them panic. Therefore, they would stay properly invested and be in a better situation over time.Â
The last disadvantage of target date funds is they tend to be more expensive than alternative options such as ETFs or low cost mutual funds.
Why Do I Need To Know The History Of Target Date Funds?
Before I answer this question, I’m going to provide some background on why target date funds have grown so much over the recent past specifically within retirement accounts.
Before the rise of target funds, when you opened a retirement account through your employer such as a 401(k) the default investment was cash.
Since most people are beginners when it comes to 401(k)s, they open the account and do not know what to do next. Therefore, they leave it in cash.
There in lies the problem… for financial service companies.
When you have an investment in cash they collect little to no fees or they have a hard time justifying why there is a fee. Therefore, they want you invested.
So the financial services industry came up with a solution. They illustrated to congress and regulators why both cash is a bad investment over time. They also showed how investing in a “cookie cutter” solution like a target date fund was bad as well.
However, their point to congress and regulators is that most people do not change the default investment selection on their retirement accounts. Therefore, target date funds, although bad, are better in the long run than simply staying in cash.
Of course, they back their reasoning with academic non-real world examples as well as some lobbying money. Just like that, target date funds were made the default election in retirement accounts.
Therefore, the growth in target date funds is not due to people wanting to be in them but being put in them by default and not knowing anything different.
Should I Use a Target Date Fund Within My 401k Or Should I Use One At All?
In my opinion, no. The fact that they completely ignore the risk in your overall finances if enough for me to state that I’m solidly against using target date funds.
However, there is a time and a place.
For example, if you are saving for a specific liability that you owe such as the tax on student loan forgiveness then they can be good.
Also, if you want to be extremely hands off then they can be OK. However, for the fees you are paying you are most likely better off using a robo-advisor or using a hybrid robo-advisor like the one FitBUX has. Yes, they cost fees but at least you get something for those fees.
Conclusion
Target date funds are popular because they offer consumers a hands-off approach to investing. However there are major drawbacks to consider before investing in one.
When deciding whether or not to use a target date fund within your 401k, it’s important to weigh the pros and cons carefully to see if it’s right for you.
If you’re not sure where to start when it comes to financial planning and investing, become a FitBUX member. Our technology and coaches can help you get started on your journey to financial freedom.
By Joseph Reinke, CFA
