The Downside of Target Date Mutual Funds

Written by Nickel - 17 Comments

Up until about a year ago, we relied primarily on Vanguard’s Target Retirement funds for our long-term investments. For those that aren’t familiar with them, these funds (and others such as the Fidelity Freedom funds and TIAA-CREF Lifecycle funds) are designed to provide an “appropriate” asset allocation based on the date at which you expect to need access to your money.

Not surprisingly, the more time that you have, the more aggressively these funds invest. Over time, however, they’re designed to automatically move to a more conservative allocation. Thus, they’re a very convenient “set and forget” solution. That being said, they’re not for everyone.

Why we abandoned target date mutual funds

As I alluded to above, we ultimately moved away from target date funds in order to gain more control over our money. We now hold a mix of low-cost index funds at our own, self-determined “ideal” allocation. Here were my four biggest concerns that caused us to move away from target date funds:

  1. Inappropriate allocation. The main reason that we moved away from Vanguard’s Target Retirement funds was that they were too aggressive for our taste. For example, the Target Retirement 2035 fund had an allocation of 90% equities and just 10% in bonds. While we could’ve simply selected another, less distant year, we didn’t like the way these less aggressive options re-adjusted down the line. Which brings us to…
  2. Inappropriate “glide path.” The glide path refers to the way in which the overall allocation changes over time. In our case, if we had chosen a less distant target date, we would’ve gotten an appropriate allocation in the near term, but it would’ve become too conservative too quickly. In short, we’re looking for a flatter curve — i.e., a bit less aggressive up front, but with a slower transition toward an ultra-conservative mix on the back end. After looking around, we simply couldn’t find the right balance.
  3. No control over what goes where. I’ve written in the past about optimizing the location of your assets to maximize tax efficiency. In general terms, you want tax-inefficient investments (such as bonds) in a tax-sheltered account, and so on. But with target date funds, you lose the ability to do this. Indeed, each and every share is composed of both stocks and bonds, meaning that you can’t separate your holdings by account type.
  4. Continuous rebalancing. While the auto-balancing offered by these funds is convenient, the fact that they’re continuously rebalanced means that you never really “let your winners run.” While rebalancing recommendations vary, the conventional wisdom is that you should do it periodically (say every six or twelve months) or when your allocation is more than a certain percentage out of whack. Doing this forces you to sell high and buy low.

Defining proper allocation

Another interesting point when it comes to target date funds is that the definition of an “appropriate” allocation not only varies across fund families, but can also change on a whim. In fact, back in 2006, Vanguard decided to reduce the bond exposure in all of their funds with a 25+ year time horizon from as high as 24% to just 10%.

While I’m not sure of Vanguard’s reasoning when it came to making these changes, I’d be willing to bet that it had at least a little to do with performance chasing. After all, most investors look at past performance when comparing funds, so taking a more conservative stance in a rising market is a great way to lose business. Of course, the past year has shown us the price of being overly-aggressive.

Published on April 12th, 2009 - 17 Comments
Filed under: Retirement, Saving & Investing
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About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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Comments (scroll down to add your own):

  1. I’m not big on letting the winners run. Once they win they are outpacing the market, this sets up the possibility of a big loss. Instead I support selling a winner to reinvest in a loser.

    But you make a good point about the asset allocation in the target retirement funds. Though they are close to “set it and forget it” they aren’t perfect. If a fund isn’t in line with your investment goals then you need to send a message to the fund by pulling your money out. For now I do have holdings in a 2050 because it’s the best fund offered in my 401(k). I’m also quite young and so have no problem being heavy in equities. I like your thoughts though Nickel.

    Comment by the weakonomist — Apr 12th 2009 @ 10:27 pm

  2. Personally, my IRA is 100% in Vanguard’s 2050. But that’s only because it matches my ideal allocation precisely.

    I’m a big fan of target retirement funds for most people. But you’re right. They’re not perfect.

    And if you are somebody who actually a) would take the time to rebalance, and b) knows what your ideal asset allocation is…then doing it on your own makes at least as much sense.

    Comment by OblivousInvestor — Apr 12th 2009 @ 10:35 pm

  3. I agree that you don’t want to ride things too long, but there’s a lot of data out there in support of periodic vs. continuous rebalancing. Just look at this past fall. Everyone with equity exposure took a beating, but if you had continuously reblanced from bonds into stocks it would’ve been worse. In our case, we’ve just let things ride and focused getting back to our target allocation with new money (still not there yet, but getting closer). Of course, this was sort of a perverse market in which our “winners” were the things that fell the least.

    Comment by Nickel — Apr 12th 2009 @ 10:36 pm

  4. Good post Nickel. For my 401k, I opt for normal funds instead of a target retirement fund as well for the same reasons. However, I do use Vanguard Target Fund for my SEP IRA which is too small to effectively diversify with normal funds.

    Comment by Pinyo — Apr 12th 2009 @ 11:23 pm

  5. I think another disadvantage (albeit minor) is that expense ratio on targeted funds are sometimes higher… for example, for fidelity’s freedom funds.. the expense ratio is around 0.8% compare with other low-cost fidelity index mutual funds running at about 0.23%. It’s not a deal breaker or anything, but I think it really depends on the type of fund you’ll be buying in the type of retirement account. As Pinyo mentioned, you can opt to use these targeted funds in an IRA instead of a 401k simply because of the contribution limit and funding differences.

    Comment by Cap — Apr 13th 2009 @ 2:29 am

  6. Cap: Yeah, that’s another possible problem, though the apparently higher expense ratio may be caused by the inclusion of more expensive underlying funds. I don’t think you really pay a premium over the composite expense ratio with Vanguard, though I might be wrong. The Vanguard Target Retirement funds include things like an Emerging Markets funds which has a higher expense ratio than their domestic stock funds. If you want an Emerging Markets fund as part of your portfolio, you’ll pay a bit more whether you get it through a Target Retirement fund or by purchasing it straightaway.

    Comment by Nickel — Apr 13th 2009 @ 9:25 am

  7. From Vanguard’s Target Retirement 2050 prospectus:

    “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.”

    Comment by OblivousInvestor — Apr 13th 2009 @ 9:30 am

  8. Good post, clear and to the point. It speaks well to some of the basics of investing – know what you’re investing in, understand the game being played, and be capable of managing your investments. My experience is that many in the investment sector don’t really know all that much, they’re often just sales people, so being a knowledgeable do-it-yourselfer is essential.

    Clair

    Comment by Clair Schwan of Frugal Living Freedom — Apr 13th 2009 @ 10:58 am

  9. I guess the biggest problem of the target date funds is the stock market highs coinciding with an investor’s asset reallocation dates. It is too much to leave to chance and one is better of manually re-balancing considering things other than age (risk etc).

    Comment by GM — Apr 13th 2009 @ 12:08 pm

  10. I’m currently invested in Vanguard’s Target Retirement 2050, mostly because up until this month I didn’t have enough money in my retirement accounts to do my own asset allocation. I will be doing my own asset allocation using low cost index funds because I’m looking to add a little more risk with small value funds and micro funds.

    It’s hard to speculate too much about why Vanguard changed the asset allocation in 2006, but isn’t performance chasing completely against the ideas of Vanguard? I would think it’s more due to the fact that if your retirement is 25+ years away, you don’t need more than 10% in bonds. It’s all speculation though.

    @Pinyo, with regards to your SEP IRA, why don’t you spread your asset allocation across all of your accounts? You don’t have to diversify each individual account. Or is it too much work?

    Comment by Steve @ Start-Up — Apr 14th 2009 @ 12:24 am

  11. Good points! What this downturn has shown is that even target-dated funds are not immune to drops.

    Comment by LR — Apr 15th 2009 @ 3:17 pm

  12. Target retirement funds are a great option for most investors who don’t have the time or inclination to inform themselves about investments. They’re also a great option for people who have too little money to buy 5 or more index funds (Total Stock Market, Total Bond Market, Emerging Markets Index, European Markets Index, REIT Index, etc.) and allocate them into their own mix. It takes several 10s of thousands of dollars to be able to tweak what you can get in a target fund for as little as $3,000 with Vanguard.

    I wrote a post about how I would allocate funds if investing outside of a target retirement fund here: http://www.dontfeedthealligato.....___-market

    Comment by MITBeta @ Don't Feed the Alligators — Apr 18th 2009 @ 10:27 am

  13. I’ve been feeling the same way about the Vanguard 2035 fund too. I think it’s too heavy on equities. Whatever happened to John Bogle’s personal recommendation that one should only have an equity position equal to 100-age?

    Unfortunately, all the non Vanguard target funds offered in my 401k are highly loaded with fees, so I don’t have the option to just switch to low-cost index funds. So, I guess I’ll keep sticking with the 2035 fund for now.

    Comment by BrokeLoser — Apr 18th 2009 @ 11:24 am

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