Target Date Funds: Should You?

Peter Blake’s ‘The First Real Target’

Target Date funds, each usually a ‘Fund of Funds’ made up of various mutual funds, attempt to meet, or ‘target’, an asset allocation suitable for an individual’s time horizon.

Do they succeed in doing so, or, at least, are they doing a better job at it than an employee left to her or his own devices?

Many employers now make Target Date funds available in their 401(k)s as a result of employees being overwhelmed by the choices available in their employer’s 401(k) plan.

Both sides are understandable: Employees would need to research each fund’s suitability for their retirement goals, and then determine the overall amount to contribute to the plan and the allocation to each fund. Employers wanted to provide a more effective way to ensure employees are somewhat in the right asset mix, which Target Date funds attempt to accomplish.

Target Date funds tend to be a mix of various mutual funds: Some stock funds, some bond funds.  Some actively managed, some passively managed (e.g. index funds).

Their costs, especially in a larger 401(k) plan, can be <.8%, which is pretty good for an actively managed fund

However, I tend to think of Target Date funds as a ‘Quick and Dirty’ way to do asset allocation: It works somewhat for those that don’t have the bandwidth or inclination to do fund research or to work with a Financial Planner that will recommend an asset allocation for them.

Key word here is ‘somewhat’.

Why? Because while they do intend to diversify and provide asset allocation, they tend to not perform as well as asset allocation that is tailored to the employee’s risk tolerance and timeline.  They are a ‘one size fits all’, and can fall short of where an employee needs to be as well as costing more money, in fees, than if the employee would have purchased the funds separately vs. as part of the Target Date fund, assuming they are provided as separate offerings in the 401(k) plan.

Additionally, as a Fund of Funds, the employee is getting a mix of quality: Some of the funds may indeed outperform, in excess of their costs,  the index they are benchmarked to.  But some may not, thus costing the employee more money overall in fees than if the employee would have bought the funds separately and, importantly, in an asset allocation mix that makes sense for their risk tolerance and time horizon.

Here are some things to look out for with respect to Target Date Funds:

1) What are the overall costs (expense ratio)? Contrast this cost with what it would cost to own the funds separately. Fees for Target Date funds can vary from Vanguard’s Target Date funds, which tend to be .18% to Legg Mason’s Target Date funds, which tend to be 1.32%. That’s quite a delta, and worth noting how it would impact an employee’s investment performance (fees eat into the profits realized by an employee’s account).

2) How did the Target Date fund perform during the last downturn, 2008-09?  Compare that to how the market overall performed. How well did they perform in the 2009 -10 recovery?  Again, compare that to how the market overall performed.

3) What actual diversification are you achieving with the Target Date fund? Are you getting exposure to markets you want to, such as international stocks and bonds, or is it primarily composed of domestic large cap stocks? (NOTE: Alot of actively managed funds available in 401(k) plans tend to be heavily comprised of large cap domestic stocks).

Lastly, remember that the way these Target Date funds came about wasn’t to provide better performance: It was to simplify the decision making process for employees participating in their employer’s 401(k) plans.  They basically take already existing mutual funds and ‘package’ them into a ‘Fund of Funds’…which is what a Target Date fund usually is.

So while a Target Date fund might be a great way to just get started in an employer’s 401(k) plan,  the employee will greatly benefit from taking a look at what is in the fund and what her or his options are for acheiving the risk tolerance and asset allocation she or he is looking for.

And you’d expect me to say this, so here it is:  Working with a Fee-Only Financial Planner is a way to get objective financial advice on the best, most suitable funds to contribute to in your employer’s 401(k) plan, since a Fee-Only Financial Planner will be able to look at 1) what comprises the existing Target Date fund, 2) compare that with what other funds are available to you, and 3) which option is best for you.

(Disclosure: I do not hold any positions in any Target Date funds.)