The Problem with Target Date Funds

If you've ever enrolled in a 401k plan, you probably realized that choosing a dessert from Cheesecake Factory's extensive menu would have been easier than choosing from your 401k investment options. As your eyes glazed over while scrolling through the list of available funds, you probably encountered something called "Target Date Funds" (or "TDFs"). 

These are often shown as the fund name followed by a year coinciding with your anticipated retirement date, such as:

Vanguard Target Retirement 2055

Fidelity Freedom Index 2050

Schwab Target 2040

LifePath Index 2045

• Vanguard Target Retirement 2055

• Fidelity Freedom Index 2050

• Schwab Target 2040

• LifePath Index 2045

These funds have an asset allocation (split between stocks and bonds) that changes over time as you approach your target retirement year. The closer you get to that date, the less equity (risk) exposure the fund contains. 

These funds are designed for people who simply want to get their money invested without having to think about it again. And while these investment options provide an easy solution to those with limited investment knowledge or interest, they often aren't the optimal solution.  

Varying Glidepaths

The "glidepath" of a target date fund is the timeframe in which the equity exposure in the fund is reduced. For instance, Vanguard's Target Retirement 2065 fund starts at 90% Equity / 10% Fixed Income. Over time, the equity gradually decreases to 50% Equity / 50% Fixed income at the target retirement date of 2065. After that, the equity gradually decreases even more to 30% during the first 10 years of retirement. At that point, the fund just maintains a 30% equity / 70% fixed income split.

Sounds easy and intuitive, right? 

Well, the catch is that not all target date funds follow that same "glidepath". Vanguard's TDFs follow a different path than Schwab or Blackrock TDFs. For instance, Schwab starts at 95% equity, moves to 40% equity at retirement, then moves to 25% equity over the next 20 years of retirement. Blackrock, on the other hand, starts at 99% equity, transitions to 40% equity at retirement, then stays at 40% permanently. 

Usually, your 401k plan will offer only one "class" of TDFs (either Vanguard, Schwab, Blackrock, etc.) so you don't have to pick between multiple glidepaths, however, depending on your personal financial situation, these glidepaths may not be appropriate for your stage of life, even if you do plan to retire at the target date.

Everyone is different

Your mom was right when she told you were special when you were a kid (and if she didn't, I'm sorry). Each person has different dreams, goals, obstacles, and opportunities, all of which influence how a retirement portfolio should be structured. And for that reason, there is no one-size-fits-all with investing. 

A 40-year old who didn't start saving until today will need to be more aggressive (i.e. take more risk) with his investment portfolio than someone who started saving diligently at age 25, even if they both plan to retire in 2050. 

A 65-year old retiree with a sizeable nest egg and healthy spending habits may need to take LESS risk at retirement than offered by the target date fund. Where a 65-year old who didn't start saving until later in life may need to take MORE risk than offered by the target date fund. 

Moral of the story: Everyone is different. But the target date funds have a pre-determined glidepath that prevents shifting allocations based on unique life circumstances, thereby producing sub-optimal results in the long run.  

Investment Options

It's also worth noting that the underlying investment options may be different among fund managers as well. For instance, Schwab and Blackrock include Real Estate in their TDFs, where Vanguard does not. However, Vanguard includes International Fixed Income in their TDFs, where Schwab and Blackrock do not. So if you have asset classes that are of interest to you, it's important to investigate the underlying holdings of the TDFs that your company offers. 

An Alternative Solution

A better solution for your retirement portfolio, even if limited to the other non-TDFs within your 401k, would be to create a customized asset allocation based on your unique circumstance. This allows you to create your own "glidepath" by strategically shifting from (or to) equities according to your personal needs. Here is a quick rundown on how to think about asset allocation in a retirement portfolio.  

That is not to say that all Target Date Funds are bad and should never be utilized. They may work well for some people. But it's worth a second thought before simply putting all of your 401k contributions into a TDF and never revisiting that decision. Being underweighted in equities for decades could mean the difference of hundreds of thousands of dollars at retirement. 

Your financial advisor should sit down with you and review the fund lineup within your 401k plan to evaluate the most prudent option as it relates to your overall financial plan.