Target date funds are an extremely popular option for retirement savers.
According to the Investment Company Institute, 59% of 401(k) participants use target date funds. And they’re even more popular with young savers. As of the end of 2020, target date funds accounted for 50% of 401(k) assets held by participants in their 20s.
While target date funds are one of the simplest ways to save for retirement, they’re not without their downsides. The cookie-cutter approach to asset allocation can ultimately hold back your retirement savings.
Instead, consider this very simple three-fund strategy that can help you reach your retirement savings goals.
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Three reasons it might be time to leave the target date fund behind
When you invest in a target date fund, you’re handing control over your assets to a single fund and fund manager. You don’t get any personalization or management for your unique situation, and that can cost you in the long run. Here’s how.
1. No control over asset allocation
The entire value of a target date fund is that it automatically controls your asset allocation over time. You select a planned retirement date and the fund will rebalance from stocks into bonds as you get older.
However, that might not be the asset allocation that makes the most sense for you. What’s more, most target date funds don’t use the same asset allocation. So you should be looking under the hood to see your fund’s allocation and glide path — how it shifts the asset allocation from stocks to bonds over time.
And you might be forced into a position where you have to use multiple target date funds (perhaps you prefer one fund family in your IRA, but your 401(k) doesn’t offer it; or you had a great 401(k) option, but your new employer doesn’t offer it). If so, you might not be getting what you expect. You might as well take full control.
2. No control over taxes
When you invest in a target date fund, you’re investing in a fund of funds. That means that the fund manager is buying and selling other mutual funds to maintain the balance of the portfolio.
Usually, the tax implications are minimal. Sometimes, however, a fund will have a major event that will result in a significant tax bill for fundholders. (It happened in 2021 to Vanguard investors, and Vanguard subsequently had to settle a regulatory dispute for failing to warn investors of the tax bill.) Granted, that won’t affect investors who only have tax-deferred retirement accounts, but it could severely impact those investing across both taxable and tax-deferred accounts.
What’s more, since the fund combines asset classes, there’s no room to optimize where you hold certain assets. For example, you may want to hold stocks in a Roth 401(k) or taxable account to take advantage of their better long-term growth and preferred capital gains taxes. Bonds, which produce periodic interest income, are best suited for a traditional retirement account. But Treasuries and municipal bonds may be good choices for taxable brokerage accounts because they have tax advantages.
3. You’re probably paying more than you have to
Since a target date fund is a fund of funds, you’ll often end up paying expense ratios twice: one expense ratio for the target date fund itself, and a second set of expense ratios for each fund the fund holds.
That’s not always the case, and some target date funds offer very low expense ratios, waiving those of their underlying funds. For example, Vanguard’s target date funds charge an expense ratio of just 0.08% of assets; that’s industry-leading. However, it’s still a higher expense ratio than those of its individual stock and bond index funds.
Some funds can be much worse. And when your choices are limited in a 401(k), for example, you could be looking at paying a lot more for a cookie-cutter plan than for a simple and customizable three-fund strategy.
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The only three funds you need
Constructing a portfolio all on your own doesn’t have to be complicated. In fact, you can put together a well-balanced portfolio with just three funds:
- A stock index fund;
- A bond index fund; and
- A money market fund. (Your brokerage might even use a money market fund as its cash account.)
If you’re investing in an employer-sponsored retirement plan, you might have limited options. Ideally, you’ll find a low-cost stock index fund that tracks the total market (or at least the S&P 500), such as the Vanguard Total Stock Market ETF (VTI 1.55%). The bond fund should similarly track a total bond market index similar to the Bloomberg U.S. Aggregate Bond Index; one such is the Vanguard Total Bond Market ETF (BND 1.28%).
If you’re investing in an individual retirement account (IRA) or taxable brokerage account, the world is your oyster: There are plenty of options. Be mindful of expense ratios, and be sure the funds track appropriate indices for your goals. If investing in a taxable brokerage account, for example, you may want to consider a Treasury bond fund or municipal bond fund for the tax advantages those securities offer.
Finding your asset allocation
When you’re determining your asset allocation for each of your three funds, it may be wise to consult some target date funds. Each fund family publishes its glide path, which shows how its asset allocation changes over time. You can use that as a reference point for constructing your portfolio.
You can adjust the asset allocation as you see fit, though. If you have a higher risk tolerance, you may want to invest a higher percentage of your portfolio in equities for longer. If you have a low tolerance for market fluctuations, putting more into a money market account or cash account may be a smart move.
You may also want to increase exposure to stocks in retirement. Many target date funds move heavily into bonds in retirement, but that ignores assets outside of your investment portfolio such as Social Security, which is very bond-like.
Be sure to periodically rebalance your portfolio to keep your asset allocation in line with your plan. Simply rebalancing once per year produces results just as good as more complicated rebalancing strategies.
While it’s a little extra work to manage a portfolio instead of the set-it-and-forget-it investing style of target date funds, it can be well worth it.
