Target Date Funds: Simplifying Simple

If you’ve been a reader of FFWF for a while—and if I’ve done my job correctly—by now you realize that investing can both be simple and effective. In fact, taking this notion a bit farther, simplicity is more than just a passive benefit—it’s power. Why? Because simplicity keeps you connected to your money. A lot of the time, adding complexity means more people involved in your plan, which leads to two things:

  1. Added costs
  2. Far lower odds that you will match—let alone exceed—the market’s return

These two things are intrinsically linked—and inseparable. I tend to think of each person involved in my financial plan as a cost layer. Taking this view means that I don’t just accept them haphazardly—they have to justify their presence in my financial life. Some, like tax professionals, are to me worth their weight in gold; far too many, unfortunately, are simply parasitic. This is why it’s my belief that most investors are better off selecting an asset allocation that is suitable for their goals, and meeting that allocation with as few broad-market, low-cost index funds as possible. For most investors, this can be accomplished with anywhere from one to three funds—the picture of simplicity.

…simplicity is more than just a passive benefit—it’s power.

Because, really, when it comes right down to it, isn’t that the point of all of this? To dial in an investment strategy, automate it as much as possible, and get back to the things that matter most in your life?

Given that, let’s get greedy for a moment… What if we were to ask the question: can it get even simpler? Can we simplify what is already simple? Yep—turns out, we can. Enter: Target Date Funds.

What are Target Date Funds?

Odds are, you’ve already run into them at some point, typically inside an employer-sponsored account like a 401(k). You know, they’re the ones that dominate your fund menu with cryptic names like Fidelity Freedom 2065 Fund (I half expected to read in the prospectus, “Investing in this fund will soon have you standing atop a sweeping vista, hair blowing in the wind, your hands thrown high in elation!“), and dates that seem to stretch out to the end of time. (Who among us can really picture our lives in the year 2070?)

So, what are they? Target Date Funds (sometimes called “Target Retirement Funds” or “Life-Cycle Funds”) are a type of mutual fund called  “funds of funds.” Semantic craziness aside, what this actually means is that they are mutual funds comprised of…other mutual funds.

How does this work? Remember that a mutual fund is simply a collection of other assets (typically stocks or bonds). By buying a share in a mutual fund, you buy shares of all the assets that make up that fund. A mutual fund may be designed to give exposure to the U.S. stock market, a particular sector, emerging international markets, corporate bonds, and so on.

Most investors who want exposure to several of these asset classes would buy multiple mutual funds (or ETFs) to accomplish this; for example, one might buy shares in a U.S. stock market fund and a U.S. bond market fund in order to get exposure to both U.S. stocks and bonds. Funds of funds simplify this. They essentially allow you to invest in multiple mutual funds by buying shares in a single mutual fund.

An example will help. Vanguard has several funds of funds, with the most notable being their Target Retirement Fund series. These funds are made up of four separate index mutual funds: 

  1. A total U.S. stock market index fund
  2. A total international stock market index fund
  3. A total U.S. bond market index fund
  4. A total international bond market index fund

So, by purchasing a share in one of their Target Retirement Funds, you are buying shares in each of those four funds—which in themselves buy shares of the stocks or bonds that comprise them. Yes—funds of funds are essentially the investment equivalent of the movie Inception.

(A quick side-note: this description is actually a bit simplified. Technically, Vanguard’s mix includes not four, but five funds. A few years out from the target date, their Target Retirement Funds add in some TIPS exposure in the form of Vanguard’s Short-Term Inflation Protected Securities Index Fund.)

Glide Path

What differentiates Vanguard’s different Target Retirement Funds from each other is their respective mix of those four funds—and the risk and performance profile that comes with each mix. And this brings us to one of the main benefits of target date funds: they adjust their asset mix (and thereby, their risk profile) automatically, growing more conservative as the target date on the fund approaches. The reason this is a benefit may not be immediately obvious, so let’s take a moment to consider it.

You might remember from our discussion on asset allocation in the FFWF Guide that your portfolio’s allocation should be based on two factors: your time horizon, and your personal tolerance for risk. We’ll talk more about risk tolerance a bit later, so let’s look at time horizon for a moment. Generally speaking, when people are younger (decades out from retirement), they can afford to be a bit riskier (i.e. growth-focused) with their investments, as they have the time for the market to correct any dips they might run into. As people get closer to retirement age, however, it’s generally better to shift some of that focus from growth to preservation of capital. In terms of asset classes, this typically means investors will hold most (if not all) equities early on in their investment lifetime, and then shift some of their mix to bonds and cash as they approach retirement. This transition over time is called your portfolio’s glide path

As it happens, target date funds are designed precisely to make these adjustments for you automatically. Let’s look at how this works in reality.

Vanguard’s Glide Path

Vanguard’s fund research site has a very useful visual of what this looks like for their target retirement funds. In the chart below, you can see that the fund starts out (on the left) very aggressive—with roughly 90% of the fund in stocks (domestic and international), and about 10% in investment-grade bonds.

Source: Vanguard

Watch what happens as we move to the right, however—and zero in on the target date of the fund. The percentage of the fund given to stocks gradually diminishes, giving up that space in the fund to fixed income (bonds). By the time we’ve reached the target date, in fact, the fund has gone from a 90/10 split of stocks/bonds to a 50/50 split. Follow it further, and into one’s retirement years, and the allocation further reduces stock exposure in favor of fixed income/cash exposure. All of Vanguard’s Target Retirement Funds eventually fold into Vanguard’s Target Retirement Income Fund (VTINX), which is an income-based fund designed for those in retirement, and has an overall allocation of roughly 30% stocks to 70% bonds.

Drawing it all together, then, Vanguard’s Target Retirement Funds offer a ready-made portfolio in a single fund—kept low-cost, and extremely well-diversified. In addition, they allow you to simply pick a planned retirement date, and let the fund do all the adjusting and rebalancing work for you. It’s all very easy. Most people can contribute to this one fund for their entire investment lifetime, and have a solid portfolio kept very simple.

Target date funds also have an added bonus beyond convenience. Readers of FFWF, by this point, know how much focus I put on investor behavior as a driver of success. The reality is that, underneath it all, we are creatures that are largely governed by our feelings and emotions—and this becomes even more the case when finances are involved. The thing is, investing is one area in which emotion is our enemy; time and again, it drives us to make the wrong decisions at the wrong times. And because of this, the ability to stay the course goes from simply being a good practice to being an absolute imperative.

…investing is one area in which emotion is our enemy; time and again, it drives us to make the wrong decisions at the wrong times.

This is one area in which target date funds may help immeasurably. By choosing one fund with a pre-set asset allocation and pre-determined glide path, you are ceding the element of control; you are simply forced to stay the course for as long as you’re in the fund. And for many—if not most—investors, trading control for forced discipline might just be a very wise concession to make.

Fidelity’s Freedom Index Series

So far, we’ve limited our discussion to Vanguard’s series of Target Retirement Funds as an example. But how do the target date funds from other brokerages stack up? Do they hold the same asset classes as Vanguard? Do they follow the same glide path? Are they more (or less) expensive to own? Let’s take a look at a couple of examples.

(Sidenote: Because we follow an index-fund-based approach here at FFWF, we’ll be looking at—you guessed it—target date funds from these brokerages that use index funds as the underlying investments. It’s worth noting that there are target date funds which hold actively managed funds as the underlying investment; however, as we’ve talked about before, I avoid actively managed funds due to their higher costs and low odds of outperformance.)

Fidelity’s index-fund-based target date funds (say that three times fast) are known as the Fidelity Freedom Index Series. Like Vanguard’s, this series of funds has a wide array of date ranges for investors to choose from (currently all the way out through 2065). These funds have an expense ratio of 0.12%, and contain a “mix” of the following asset classes:

  • Total U.S. Stock Market Index Fund
  • Total (ex-U.S.) International Stock Market Index Fund
  • Long-Term Treasury Bond Index Fund
  • Short-Term Treasury Bill Index Fund
  • Investment-Grade Bond Index Fund
  • Treasury Inflation-Protected Securities (TIPS) Index Fund
  • International Developed Markets Bond Index Fund

It’s worth noting that not all funds will contain all of the asset classes listed above. As with Vanguard, Fidelity’s funds follow a strategic glide path that grows from aggressive to conservative depending on time horizon, and this means the mix will add or drop asset classes based on this. This is Fidelity’s overall projected glide path:

Source: Fidelity

Schwab’s Target Index Fund Series

Schwab’s series of target date index funds is known as their Target Index Fund Series, which also offers funds for a wide variety of target dates (currently out as far as 2065). This series of funds has an expense ratio of 0.08%, and is comprised primarily of index-based ETFs from Schwab from the following asset classes:

  • U.S. Large Cap Stock Index ETF
  • U.S. Small Cap Stock Index ETF
  • International Developed Markets Index ETF
  • International Emerging Markets Index ETF
  • U.S. REIT Index ETF
  • U.S. Short-Term Treasury ETF
  • U.S. Aggregate Bond Market ETF
  • Treasury Inflation-Protected Securities (TIPS) ETF
  • Prime Money Market Fund

As with Fidelity, not all of these asset classes are represented in all of Schwab’s target date funds—the mix varies with the date of the fund. Their overall glide path is as follows:

Source: Schwab Asset Management

As you can see, the index-based offerings from these major brokerages, while not identical, are very competitive: they are low-cost, well-diversified, and extremely convenient.

Do They Hit the Target?

Not everyone is a fan of target date funds. But in my experience, the main criticisms of them tend to come down to two broad categories:

  1. They contain investments I don’t want (composition)
  2. Another variation: They are too aggressive/conservative for my taste (composition)
  3. They are more expensive than a DIY portfolio (costs)

To be fair, these considerations are entirely valid, and where investors come down on them is largely dependent on their individual needs and goals. Let’s walk through an example that allows us to consider them in-depth.

Let’s say that you plan to retire near 2050 (28 years away). You’ve already gone through the process of determining your portfolio’s asset allocation, and ensured that it is anchored to your time horizon and risk tolerance. You like the overall concept of a target date fund, and decide to research Vanguard’s Target Retirement 2050 Fund (VFIFX). Checking the fund profile on Vanguard’s site, you discover it currently has the following composition:

  • 54% Total U.S. Stock Market
  • 36% Total International Stock Market
  • 7% Total U.S. Bond Market
  • 3% Total International Bond Market

Said another way, the fund is currently aggressive (an overall “mix” of 90% stocks to 10% bonds), and as we know from Vanguard’s glide path above, the fund will automatically adjust its asset allocation as you grow nearer to 2050, growing more conservative and ending up near 50% stocks and 50% bonds by its target date.

So how do we know if this fund is a good fit for your portfolio? Well, let’s go back to those two considerations: composition and costs.

So, consideration #1—composition. Here are some key questions to ask: How well, if at all, does the underlying allocation of the fund align with your desired asset allocation? (Remember that your asset allocation should always lead fund selection, not the other way around.) If you find that it doesn’t align well at all, try choosing a fund with a target date that’s closer to what you want. For example, if you thought the 2050 fund was too aggressive, you could try the 2045 or even 2040 fund, which will be more conservative; if, on the other hand, the 2050 fund was too conservative, try evaluating the 2055 or 2060 fund, which are more aggressive. Something else to also consider: how well, if at all, does the planned glide path of the fund align with the glide path you want your portfolio to follow?

On to consideration #2—costs. It’s important to note that there is a slight cost differential in holding a target date fund, as opposed to holding the funds individually; this goes towards the management of the fund. This cost difference, however, is typically not very significant. For example, our fund (Vanguard’s Target Retirement 2050 Fund, VFIFX) has an expense ratio of 0.08%. Were you to hold the same portfolio on your own—using individual funds instead—this would mean an expense ratio of 0.07% on your portfolio. That’s a difference of 0.01% in costs, or $1 per $10,000 invested. So the question in our example becomes: is the added convenience of a target date fund worth $1 per $10,000 invested? (Some target date funds may have a larger cost differential, so it’s important to look on an individual basis. And whether that is worth the added convenience or not is of course up to you.)

This brings me around to the advice I usually give when someone is asking about a target date fund. Provided that 1) the fund aligns with your desired asset allocation, and 2) the convenience is worth the additional cost, target date funds might be a perfect, simple investment option for you. Ramit Sethi sums it up nicely in his book I Will Teach You To Be Rich:

“Target date funds aren’t perfect for everyone, because they work on one variable alone: when you plan to retire. If you had unlimited resources—more time, more money, and more discipline—you could conceivably squeeze out slightly better returns by building a custom portfolio based on your exact needs…[but] for many people, the ease of use of these funds far outweighs any minor loss of returns that might occur from taking the one-size-fits-all approach” (239).

Final Thoughts

There are two more things worth mentioning regarding target date funds. The first is that they work best when they are your only investment. Remember that one of the main benefits of target date funds is simplicity—the ability to hold a ready-made, well-diversified portfolio in one fund that will automatically reallocate and rebalance as you near your planned retirement date. When you add other funds to the mix, this has the result of increasing complexity, likely adding overlap, and can actually make tracking and rebalancing more difficult. For these reasons, I typically recommend selecting an asset allocation, and a) holding a target date fund that matches it, or b) holding individual funds in a mix that matches it—but not both.

The second thing to mention with target date funds is that, ideally, you want to hold them in tax-advantaged accounts, such as a 401k or IRA. While their underlying investments (being index funds) are themselves tax efficient, paradoxically, the target date fund itself can have a higher tax liability. Some reasons: the fund automatically rebalances and reallocates over time—causing buying and selling inside the fund which (in addition to redemptions) can lead to capital gains distributions that are passed on to shareholders; as the fund approaches its target date and grows more conservative, this means a higher allocation to taxable bonds, which spin off interest payments that are taxed at investors’ marginal tax rate; and so on. The simple answer is—to ensure you are minimizing your tax impact, try to hold target date funds inside tax-advantaged accounts whenever possible.

And there you have it—everything you never knew you wanted to know about target date funds! For many investors, they can be (and are) a very simple, well-diversified, low-cost solution to the problem of portfolio management. For these reasons, they are well worth considering for your own portfolio—provided that you keep a few considerations in mind.

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