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Target Date Retirement Funds: The Pros and Cons

For many retirement savers, target date funds have become a popular option. For TSP, 401(k) and 403(b) participants, a target date or lifecycle fund is often the default option. IRA investors can easily choose a target date fund and turn the set-up process into a task that takes little more than minutes. However, like everything, target date funds come with benefits and downsides. Read more to see if a target date fund is right for you.

Pros:

- Initially easy: Perhaps most importantly, target date funds make getting started with retirement saving easy. I like to call it “the slow cooker of investing.” I love getting a slow cooker recipe going in the morning and knowing that dinner will be ready at the end of the day. Target Date funds are designed in much the same way. Based on the stated target year, the glide path is designed to reduce risk as the investor ages. Reducing investment risk in the years leading up retirement limits the possibility that a major market downturn could derail retirement plans.


- Continued low effort: There is virtually no management needed by the investor for a lifecycle fund. Instead investors pay a team of managers through the fund’s expenses. Simply putting money into the account is all that needs to be done. This is especially valuable in times of volatility when people are tempted to make drastic changes to their portfolio when their best action is probably to do almost nothing at all.


- Useful for non-retirement goals too: Target date funds can be used in non-retirement accounts for goals that are time-bound but necessarily for retirement. For example, a military service member could use a target date fund to save for a home down payment for the year that they anticipate separating or retiring.

Cons:

- Target Date funds may not match an investor’s risk profile: The asset allocation, or stock/bond balance, varies from one target date fund to another. For example, in early April 2020 some popular funds looked like this.

Fund Name Stocks Fixed Income/Bonds

Fidelity Freedom 2050 92% 8%

Vanguard 2050 89.5% 10.5%

TSP Lifecycle 2050 81.5%. 18.5%

Holding a higher percentage of stocks may generate higher returns but not without the likelihood of larger losses when things go bad. Investors who base their investment decisions solely on past performance may select a fund that is well above the risk they can emotionally tolerate.


- Not going all-in: One of the most common investment mistakes I see investors make is choosing a target date fund for part of their account along with a mix of other investment funds. For example, an investor may have 50% in a target date fund and the other 50% split between a blue-chip fund and cash (that’s roughly the C Fund and G Fund in the TSP). It’s not that any of these funds are inappropriate in and of themselves, but that the selection is largely due to a misguided attempt at diversification. Target date funds are designed using Modern Portfolio Theory, a mathematical method of optimizing return for an expected level of risk. Mixing non-target date funds with a target date fund almost guarantees that the risk-return balance will be less than optimal. Not only that, but rebalancing becomes more difficult as well.


- Target date funds may be more expensive: Some target date funds are considerably more expensive than building a portfolio of passively managed index funds. And we should all be able to recognize that higher fees mean lower lifetime returns. That said, if an investor is not committed to the task of periodic rebalancing then having a fund manager may be worth the extra cost.


- Retirement date is not the same as withdrawal date: The default option for a target date fund is usually the year in which an investor turns 65-years-old. This however, may not be the year that withdrawals are actually expected to be taken. An investor who plans to withdraw earlier may be taking too much risk whereas an investor who is reserving the money for much later would be sacrificing returns.

I believe that for many investors, a quality target date fund like those offered by Fidelity, Vanguard, and the TSP are an excellent choice. It’s important not to let the pursuit of perfection get in the way of progress. If a target date fund is what gets a beginning investor started, keeps someone from trying to time the market or allows more time for the important parts of life (like watching my kids play in the spring rain as I wrote this post), then that’s nothing short of a win.

One of the hardest parts of life is knowing when enough is enough. There is something to be said about keeping it simple and moving on.

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