Target Date Funds- Pros, Cons, and Whether They’re a Good Investment for FIRE
Target date funds (TDFs)are very popular retirement investments. They’ve become so popular that many people think that TDFs are the catch-all when it comes to retirement investing, and the majority of US employers are automatically enrolling their employees in 401(K)- type plans comprised of TDFs.
But are target date funds really that good of an investment? Keep reading to learn the pros and cons of target date funds and how they relate to financial independence.
Despite their popularity, target date funds are NOT the best choice for those pursuing FIRE. Over the decade Amon and I have been pursuing FIRE, we never once invested in TDFs, and now that we’re officially financially independent we can confidently look back and say that choosing not to invest in TDFs was the right decision.
What Are Target Date Funds?
target date funds were first established in the early 1990s but didn’t become really popular until 2006 when the Pension Protection Act was passed. The Pension Protection Act allowed plan sponsors to automatically default people into target date funds, thereby increasing the use and popularity of the funds.
A target date fund is a mutual fund made up of other mutual funds. It is essentially a “fund of funds”. Usually holding a mix of stocks and bonds, the TDF was “designed to be simple, long-term investment vehicles for people with a specific retirement date in mind”.
TDFs are often described as age-based retirement investments that take more risk when you’re young by investing primarily in stocks and become more conservative, shifting towards more bonds, the older you get. This is based on the understanding that young people have more time to recoup potential losses associated with aggressive, high-risk/high-reward, all-stock strategies.
TDFs usually contain both index funds (which we love) and actively managed mutual funds (which we don’t because they usually cost more and underperform index funds). So when deciding whether or not to invest in a TDF, make sure to understand exactly what the TDF is investing in.
Pros of Target Date Funds
1. TDFs Invest In Other Index Funds
I’m a huge fan of index funds. They are the most efficient way to build wealth when it comes to investing in the stock market. Again though, TDFs don’t always invest in index funds so make sure to do your research to see if this “pro” applies.
2. TDFs Are Easy To Use
They are the definition of automation! All you do is pick your target retirement year, deposit your money, set it, and forget it!
3. TDFs Provide Diversification
TDFs are designed to invest in both stocks and bonds which makes the portfolio less volatile.
4. TDFs Are Rebalanced
TDFs automatically rebalance themselves which can be really appealing for people who want to make the process as simple as possible and don’t want to rebalance their portfolios themselves.
Cons of Target Date Funds
1. Simplicity Leads to a Lack of Research
The fact that TDFs are so simple and easy to use may be appealing, but this simplicity is also what makes TDFs dangerous. When people see how simple it is to invest in TDFs, they tend not to bother really understanding what they’re investing in. This means that it’s really easy to just fall asleep at the wheel bc you can fall prey to some pretty big mistakes.
To illustrate this point, let’s look at 2 different TDFs offered by Fidelity with a 2055 target date. Upon first glance, both funds look almost identical, but upon delving deeper you realize that there are significant differences. The first fund, the Fidelity Freedom 2055 Fund, invests in index funds and actively managed mutual funds. On the other hand, the second fund, the Fidelity Freedom Index 2055 Fund, only invests in index funds. Not only that, but the expense ratios, yields, and year-to-dates are all different as well.
Now, if you just looked at the titles, you might have decided to invest in the first fund without even looking to see if there were other options, or what the differences between the options were. And this is exactly why you need to look at more than just the retirement date! Remember, not all TDFs are created equally and many people just focus on their retirement date when selecting a TDF and nothing else, which can result in higher fees and lower returns.
2. You’re Stuck with the TDF’s Investments
If the TDF invests in 3 different index funds, 4 different mutual funds, you have no choice but to invest in those funds. You can’t pick and choose different funds or fiddle with the ratio of index funds to mutual funds. There is absolutely no personalization or flexibility- you’re stuck with the whole pot!
3. TDFs are Too Conservative
Let’s say, for example, you’re a 21-year-old investor with a retirement target of 65. In this case, the TDF would still have bonds in it, even though you have 45 years until retirement! At this age, your portfolio should be comprised of 100% stocks! This is even more significant for people who are pursuing FIRE because the target date would have been a lot sooner. If you’re 30 and set your target date to 10 years from now, the majority of your TDF would be made up of bonds, which won’t provide the returns needed to maintain your portfolio during retirement. I’ve mentioned the 4% rule before, but to summarize, the rule refers to the idea that a portfolio mix of bonds and stocks that is too conservative is more likely to run out of money than one that is more aggressively weighted with stocks.
Yes, there is risk involved in having most of your money in stocks- what if, for instance, the market suddenly crashes? But there are ways to work around this. For example, Amon and I have 2 and a half years’ worth of expenses saved in an emergency fund so that if the market ever does crash, we don’t have to pull our money out until the market recovers a bit.
4. TDFs Offer No Flexibility To Choose Which Holdings to Buy or Sell
If you notice, for instance, that there is just one particular bond that isn’t doing so well, you can’t just go in and get rid of just that bond. You have no choice but to sell the entire TDF. This means that if you want to sell one holding, you have to also sell the other holdings, even if they’re performing well. It’s all or nothing with TDFs. This is particularly significant for those pursuing FIRE because once you achieve financial independence and are living off of your investments, flexibility in selling portions of your holdings is crucial.
5. TDFs have High Expense Ratios
The average expense ratio for a TDF is 0.7%. On the flip side, if you look at some of the other index funds on the market (index funds, not TDFs) you can find expense rations for 0%!
Ultimately you can save money by creating your own portfolio of similar index funds and avoiding expense ratios altogether. Yes, this approach requires a bit more work because you’ll have to rebalance yourself, but this really isn’t too hard to do!
6. TDFs Perform Worse Than Balanced Index Funds
TDFs typically underperform when compared to the average index fund. As I mentioned, TDFs can either invest in just index funds, or both index and mutual funds. In the first case, you can easily just go buy the same index funds yourself. And in the second case, those actively managed mutual funds are probably dragging your entire portfolio down (as mutual funds historically perform a lot worse than index funds). Either way, the result is a more rigid, less profitable portfolio.
So, while there are some benefits to TDFs, if you ask me, the cons of TDFs outweigh the pros for folks pursuing FIRE. Ultimately, your investment plan is just that: YOUR investment plan! You should decide how your money is invested and you should have full control over your portfolio. At the end of the day, TDFs just don’t allow for that.
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