Target date retirement funds are designed to be simple. Pick the fund with the date closest to your expected retirement year, and the fund company handles the rest. The fund starts with more stocks when you are young and gradually shifts toward bonds as you age.
In this article, I will explain why target date funds are not a good choice. Before I do, I want to be clear: A target date fund is better than not investing and better than leaving retirement savings in cash. But better than nothing is not the same as good, and a simple choice can still be the wrong choice. Defaulting to a target date fund can cost you dearly.
Each target date fund has a glide path which increases bonds from age 20 to a presumed retirement at age 65 and then continues in bonds through a person’s retirement years. Generally speaking, glide path of bonds is a good idea. However, one of the biggest problems with target date funds is that they have too much in bonds at every age.
While each company’s target date funds has a different amount of bonds at each age, all of them dampen returns because they have too much in bond investments at too early of an age.
Ideal bond allocation targets are based on withdrawals.
In the ideal, the optimum amount of stability is not determined by your birthday nor by how many years until you are going to retire. It is determined by your upcoming withdrawal needs.
When you invest money in the stock market, that money may rise above the value where you invest or fall below that value as the market moves up and down. But at some point the value will rise above the value where you invested never to fall below that value in the future. The average number of years it takes the stock market to do that is around 3.9 to 4.1 to 5.5 years.
For investors who need money in the next five years, having that money in a relatively stable asset class such as bonds can be important.
On the other hand, one standard deviation of 7-year stock market movements is all positive. For this reason, we recommend having 5-7 years of your withdrawal needs invested in bonds. Because you have 5.5 years of spending in bonds, you likely won’t have to sell your stocks when the market is down in order to spend money on your lifestyle. Having longer than 7 years of spending in stocks lets you enjoy the long-run appreciation of the market.
When you are more than 7 years from retirement, your savings (the money you don’t spend from your earned income) acts like a bond coming due every month. If you were to lose your job today, you would tap the savings margin from yesterday’s income and your emergency fund (which we recommend to be at least 3 months of your spending) while you look for a new job. If you have insecure wages, the solution is living more frugally to create a Stability allocation from your savings, not having a bond allocation.
In this way, if you do not have any planned retirement spending in the next seven years, your optimal retirement asset allocation is 0% bonds and 100% stocks.
If you are planning on retiring at age 65, you don’t need any bonds until you are at least 55 years old. That gives you ten years to build up seven years of planned spending in bonds. Gradually moving money from stocks to bonds when the market is acting normally is appropriate. But taking money out of stocks when stocks are down is harmful to the plan whether you do it seven years in advance as you build up a bond allocation or because you have to spend it.
Target Date Funds have too much in bonds.
In this article, I am going to use Vanguard retirement date funds as an example. We like Vanguard funds generally, but Vanguard target date funds still have too much Stability (bonds).
Here is a chart of each Vanguard target date fund, what age they are intended for, how many years until an expected retirement at age 65, how much Stability each fund has, how much Stability Marotta would recommend for an age-appropriate asset allocation, and how much excess stability you have if you invest in a target date fund.
| Fund | Age | Year until Retirement at 65 | Vanguard Stability | Marotta Stability | Excess Stability |
| VSVNX | 21 | 44 | 9.00% | 0.00% | 9.00% |
| VLXVX | 26 | 39 | 9.00% | 0.00% | 9.00% |
| VTTSX | 31 | 34 | 9.00% | 0.00% | 9.00% |
| VFFVX | 36 | 29 | 9.00% | 0.00% | 9.00% |
| VFIFX | 41 | 24 | 9.80% | 0.00% | 9.80% |
| VTIVX | 46 | 19 | 17.10% | 0.00% | 17.10% |
| VFORX | 51 | 14 | 24.20% | 0.00% | 24.20% |
| VTTHX | 56 | 9 | 31.60% | 12.39% | 19.21% |
| VTHRX | 61 | 4 | 36.50% | 26.33% | 10.17% |
| VTTVX | 66 | -1 | 50.30% | 28.38% | 21.92% |
| VTWNX | 71 | -6 | 64.70% | 31.17% | 33.53% |
| VTINX | 76 | -11 | 68.20% | 35.15% | 33.05% |
Some investors try to solve target-date funds having too much in bonds by choosing a target date fund 5 or 10 years beyond their actual retirement date. This does not help. First, the ideal and target date fund glide paths have very dissimilar shapes. Second, there is no target date fund without a bond allocation. So, even if you choose a target-date fund 10 years beyond your actual retirement date, you will still have too much in bonds at nearly every age.
Additionally, as an aside, most target date funds move more conservative as you age regardless of what might be happening in the markets. However, we’ve found it is better avoid moving more conservative during a bear market; instead, we advise waiting until the markets have fully recovered.
The cost of too much in bonds is high.
Because bonds reduce expected growth, all of these excess bonds have a cost.
In “The Rate of Return on Everything, 1870–2015 “, equities averaged an 8.34% real return, while long-term U.S. government bonds averaged a 2.79% real return, a gap of 5.55 percentage points. That means every additional 1 percentage point allocated to bonds instead of stocks has historically reduced expected average return by about 0.055% per year, or about 5.5 basis points.
A basis point is one one-hundredth of a percentage point. Five and a half basis points may sound small, but the compounded loss may be huge. If a target date fund is 20 percentage points more bond-heavy than necessary, that could reduce expected return by roughly 1.1% per year. Over decades, that is a large price for unnecessary stability.
This is why your asset allocation should be priceless. The value of not running out of money cannot be measured. But that does not mean you should buy more safety than you need. Too much safety can quietly lower the standard of living your retirement assets can support.
The lowest allocation to bonds in a typical target-date fund is about 10%. But you don’t need to consider bonds until you are within at least 10 years of retirement. Target-date funds give you 10% more allocation to bonds for at least 35 years.
Why do target date funds get this wrong?
You might ask why target-date funds hold too much in bonds. This is a product of government legislation.
A fund in which retirement plan sponsors can automatically invest participants is called Qualified Default Investment Alternative (QDIA). By law, a QDIA must be “a mix of equity and fixed income exposures .” Hence by law, a 100% stock allocation is not allowed to be a QDIA.
To increase the likelihood that retirement plans include them in the line-up, target date funds include fixed income exposures at all levels. Then, to meet the requirement to provide a QDIA in the retirement plan, 65% of retirement plans include target date funds in their lineup. Then, once included, many participants blindly choose such a fund.
We considered including target-date funds in our retirement plan offering to meet the QDIA requirement. But with 42% of participants incorrectly choosing target-date funds , that is too high a percentage of mistakes to let through on our watch as the plan’s financial planner.*
In “Naive Diversification Strategies in Defined Contribution Saving Plans ,” authors Shlomo Benartzi and Richard Thaler found that many investors follow the 1/N strategy. They divide their contributions evenly across the funds offered in the plan. Consistent with this naive notion of diversification, the authors found that the proportion invested in stocks depends strongly on the proportion of stock funds in the plan.
We rejected target-date funds in our retirement plans for the same reason we reject any suboptimal choice or product. We have around forty choices in our retirement plans, but we strive to exclude any choice which we, as a fiduciary, would not recommend. We encourage participants to make optimal choices by making the best path clear, simple, and easy to follow. In our ideal retirement plan implementation, we have a unitized trust as well as model portfolios. Each option is labeled or named after how many years from needing the money the portfolio is designed for.
The difference between the asset allocation of a typical target-date fund and a portfolio invested more appropriately in 100% stocks might be a difference of retiring 50% richer or seven years earlier.
We hope that knowing the value at stake makes you unwilling to settle for a choice just because it is easy. There isn’t a simple decision in most retirement plans. Instead, we recommend that you become educated on the optimum options and either seek the advice of a fee-only financial planner or use our Gone-Fishing portfolio to guide your investment decisions.
Photo by Ron Dauphin on Unsplash. Image has been cropped.
* For those interested, we pick the Vanguard STAR Fund (VGSTX) to be our QDIA requirement when one is necessary. We picked it because it is has a low expense ratio (0.29%) and a nondescript, not-tempting name. With 35.51% bonds, we hope no one younger than 75 picks it.
