Why Target Date Funds Miss Their Mark

By February 19, 2018 October 16th, 2019 Investing, Retirement

Funds that let you pick a “target date” for your retirement and invest accordingly have grown in popularity. It’s easy to see why. Analogies have been made to a plane that is now flying at 30,000 feet towards a destination – retirement – that may be 10 or 20 years or more in the future. As the plane makes its gradual descent over time, the portfolio manager shifts the fund’s allocation, reducing the share to stocks and raising the share to bonds. In retirement, the fund continues to get more conservative by adding bonds and shedding stocks. Thus, target date funds let an investor “set it and forget it.”

Target date funds are a welcome innovation for Do-It-Yourself investors and 401(k) plan administrators, but they come with significant limitations that make them a less-than-ideal retirement investment vehicle.

First, they are significantly more expensive than building a portfolio of individual ETFs. Four of the top five 2030 target date funds charge between 0.57% and 0.74% (see table below). This is 9-12x more expensive than what it would cost an individual to build a similarly diversified portfolio of ETFs (0.06%). The fifth, from Vanguard, charges much less – 0.14% – but this is still more than double the cost to DIY.

Second, target date funds don’t give investors enough exposure to foreign stocks. The United States’ share of global economic output is 25%. Because more American companies are publicly-traded (v. privately-held) and because of our greater transparency when it comes to accounting and reporting standards, the American share of the global stock market capitalization is a little more than 40%. This means that almost 60% of the money invested in stocks worldwide is invested in foreign companies. The five leading target 2030 funds allocate only 20-25% in foreign markets, however. That’s three times less than they should invest to create a truly global portfolio.

Third, target date funds are also off the mark when it comes to emerging market exposure. Emerging market countries – think China, India, South Korea and Brazil – make up about 40% of the world’s GDP. Because more of their companies are state or family owned, however, they make up only about 11% of the global stock market. A fund that aims to give its investors exposure to the totality of global growth should thus invest about 11% in the emerging markets. The leading target 2030 funds, however, invest much less, typically 5% or less.

Fourth, target date funds are not aggressive enough in their allocation to equities now and are too aggressively invested in equities in retirement. A person in their mid-40’s who expects to retire in their mid-60’s should typically have 80% of their total retirement savings invested in stocks. The leading 2030 fund, however, has only 70% allocated to equities right now. In 2030, the year of retirement, a person in their mid-60’s should have about 45% of their overall retirement savings in stocks. The leading target date funds have only 50-55% however.

For all of the above reasons, investors should re-consider using target date funds for their retirement savings. A financial advisor who is a fiduciary and who charges reasonable fees and uses low-cost ETFs can build a superior portfolio for the same price or better.

 

Eileen McPeake

Author Eileen McPeake

More posts by Eileen McPeake