Target Date Funds: In Defense of Investing Simplicity

Target date funds are investment vehicles that have gained popularity with regular people but get mediocre marks from investment advisers. Offered by most fund families (Vanguard, T. Rowe Price, Fidelity, etc.), they are frequently included as an offering in 401(k) plans. According to Morningstar, investors had about $700 billion in target date funds at the end of 2014, although their growth is slowing.

One reason for the slowing growth may be that people have been dissuaded from using target date funds because of their simplicity. They’ve been told that investing is complex, and that they need a more individualized solution than target date funds can offer. I would like to offer my two cents in defense of simplicity.

Target date funds work by allocating across asset classes based on a projected retirement date (they’re sometimes called “life-cycle,” “age-based,” or “target retirement” funds). They primarily provide access to stocks and bonds, domestic and international. A target date fund with a projected retirement that is far off, say 2045 or 2050, will allocate primarily to stocks. A target date fund with a projected retirement in the near future, say 2020, will allocate more heavily toward bonds. In other words, target date fund investments shift from aggressive to conservative as the target date approaches.

The great thing about target date funds is that they offer one-stop diversification across individual securities and across asset classes. They also change allocation over time. Conceivably, target date funds offer you an opportunity to automatically invest in a single fund, and you never have to think about or re-adjust positions for your entire life. It is portfolio management rolled it into a single, simple fund that changes as you age.

The table below looks at allocations for Vanguard’s target retirement funds for projected retirement in 2050 and 2020. The overall allocation to stocks and bonds is similar to most sample portfolios you would get from an investment adviser. For the long-term investor, the fund allocates about 90 percent to stocks. For the shorter-term investor approaching retirement, the target date funds allocate a little less than 60 percent to stocks. These funds also offer diversification to international holdings.

It seems that target date funds offer a simple solution for hands-off investors. However, a Google search of the term “target date funds” turns up plenty of articles about the pros and cons of these funds, and often emphasize the cons. Let’s take a look through the criticisms of these funds.

Criticism #1: Target date funds are not personalized enough.

This is the largest criticism of target date funds. CNBC maintains this position here and here. Many investment advisers seem to agree that target date funds don’t offer a risk tolerance that is specific to the individual. This is true, but I argue that this is precisely the reason that target date funds are a prudent investment! Target date funds are meant for hands-off investors that want someone to prescribe an investment plan for them.

There is evidence that risk questionnaires that advisors use to gauge investor risk tolerance may not do a great job. As Michael Kitces writes, “most risk tolerance questionnaires mix together an evaluation of factors that should remain separate, and as a result leads to often faulty conclusions.” When it comes to picking an appropriate portfolio, I would argue that it is preferable to have a robotic, systematic approach as opposed to a financial advisor using the results from an ad hoc risk questionnaire to come up with a plan that is likely biased by pre-conceived ideas from either the advisor or the investor.

So, while I agree that target date funds are not personalized enough for hands-on investors, I don’t think that’s necessarily a bad thing for the hands-off investor. I suspect that a lot of this criticism comes from advisors that are worried about losing business to such a simplistic approach. The more they can convince you that investing should be complex, the more they can charge for their services.

Criticism #2: Target date funds are too conservative or hold too many bonds.

The second criticism is one featured by Vanguard’s Jack Bogle. This criticism suggests that target date funds get too conservative too quickly for most investors. That is to say, as a default, that most people should invest more aggressively toward stocks than the default option in a target date fund.

I have actually made a similar argument that people tend to invest too conservatively in general as they approach retirement. The gist is that for those who have a significant and reliable retirement income stream (Social Security and pensions) 401(k) plans should be allocated more aggressively. Similarly, Rob Arnott of Research Affiliates argues that savers would be better off using a rising allocation to stocks as they approach retirement. Despite evidence that perhaps declining risk tolerance as retirement approaches may not be optimal, I don’t have a problem with how target date funds are constructed.

Target date funds are constructed based on the theory of human capital. The theory behind this framework is that people experience diminishing “human capital” as they age. In other words, they have fewer working years in which they can count on steady income. Human capital is considered a safe asset in the balance sheet. As human capital decreases, it stands to reason that a greater share of financial assets should be allocated to safe assets such as bonds and treasuries. Although there is evidence that this framework may not be ideal, this is how people tend to invest. This asset allocation framework is commonly accepted, and though it isn’t my framework of choice, I don’t fault people for sticking with this tried and true model. If your appetite for risk leans to the conservative or moderate side, this may be a simple way to carry out your investment plans.

People without target date funds usually invest in portfolios similar to target date funds by age. If you look at a “moderate” or “conservative” sample portfolio from AAII, they include either 30 percent or 50 percent bonds. The moderate portfolio, suggested for people aged 35-55, is actually more conservative than most target date funds. Even though I agree with the assessment that people may be too conservative with their investments as they approach retirement, I don’t think this problem is unique to target date funds. These funds are just offering a common approach that people are comfortable with.

Criticism #3: Target date funds don’t offer exposure to alternative investments.

This is another true point. Target date funds typically don’t offer exposure to emerging markets, private equity, REITs, gold, and other alternative investments. This is probably the criticism that I most agree with. I think that exposure to these assets, along with a tilt toward value and small cap stocks, can have the effect of increasing risk-adjusted returns over time.

On the other hand, target date funds are perfectly adequate for most investors. I think that sometimes adding a bunch of different asset classes can only confuse and cloud risk exposure. The difference in returns from these alternative asset classes is likely at the margins, and in the case of most investors, simple may be better. There are better ways to create a more financially rich future, most notably by saving more.

Criticism #4: Target date funds are too expensive.

This criticism has largely gone by the wayside as fees have continued to decrease, but it remains a valid concern. Fees on the Vanguard funds are the best in the industry, 0.17 percent per year. Across all target date funds, fees average about 0.66 percent. That is a little higher than you’d pay if you were able to invest directly in index funds.

However, many investors may not have a choice about which funds are available in their retirement plans. If there is a limited selection of low-cost index funds available, it may be worthwhile to use target date funds. Actively managed funds routinely charge anywhere from 0.5 to 1.5 percent, meaning a 0.75 percent fee on target date funds is reasonable. I hate fees with a passion, but if your retirement plan options are limited to funds that charge these kinds of fees, it may make a lot of sense to use target date funds for the simplicity of it. Check Morningstar.com for fund fees.

Wrapping up

Target date funds are not for everyone, but I think they’ve come under unfair criticism from some sources. I’ve come across several people that have been dissuaded from using target date funds because they’ve been told they’re too simple. People don’t want to be thought of as simple.  The result is that people will hold a small share of their retirement portfolio in target date funds, but then further “diversify” with a bunch of other mutual funds. This probably adds no actual diversification, since target date funds hold thousands of stocks and bonds across a variety of countries.

Target date funds offer an opportunity to reduce your portfolio to a single holding that is broadly diversified across individual securities, across asset classes, and across countries. That’s a lot of diversification within a single investment! For investors with more complex retirement plans or with a desire to get more hands-on with asset allocation, there may be more cost-effective and customizable solutions. However, for the hands-off investor planning for retirement, target date funds are a prudent option.

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