Target Date Funds Still Stink

What to do when your only choice is target date funds.

ETF.com did a kind of where are they now on target date ETFs. Apparently there are no more target date ETFs after iShares and Deutsche Xtrackers closed up target date shop. Then there was discussion about how target date mutual funds (so traditional mutual funds with a five letter symbol ending in x) are increasingly using ETFs to build their allocations.

The idea of using ETFs to build and manage a portfolio toward some sort of objective has of course become increasingly prevalent over the years do they're being used in target date funds certainly makes sense, I have no bone to pick with that.

Where target date funds continue to be widely offered in 401k plans I wanted to weigh in on why I think they are generally a terrible investment vehicle. They are better than nothing as in literally no other alternatives in your plan but if there are alternatives in your 401k like a plain equity index fund, a bond fund and some sort of cash proxy then it would be better to use those instead of target date funds.

I've always thought target date were a lousy way to go, here is a post from 2010 making a similar point. The biggest problem is the inconsistency with how fund providers change their asset allocations as the funds move closer to their retirement dates. It is not that there must be uniformity but it becomes very difficult to know what "glide path" the funds available to you will choose. Target date funds generally have a lot of equity exposure when the retirement date is far off and then they increase fixed income exposure as time goes on.

During the financial crisis there were a lot of target date fund families with kind of close retirement dates that had a lot more equity exposure than fund holders thought. Investopedia wrote an article titled Bear Market Mauls Target Date Funds that gives some good history, I also have a personal anecdote for a plan our company manages. Someone looking to retire five years from now, or less, while markets are today at just about all time highs, may not want 70% in equities as some target date funds had.

Similarly, if the market cuts in half a few years before you retire you might want to increase equity exposure some after that decline. The tech wreck and the financial crisis are very recent reminders that markets stop going down at some point and then go on to make a new high...eventually. A target date fund doesn't necessarily offer that sort of tactical flexibility to capitalize on that reality but if target date funds are the only options in your 401k there is a way to manage your own asset allocation however you see fit.

First is you need to decide what is a suitable asset allocation between stocks and bonds. We have in the past and will in the future explore what the right mix might be but for now I will simply say that one way or another, whether someone else helps you or you do the work yourself, you need to pick the right mix. From there, look at the target date funds in your plan. The fund with the furthest date into the future is most likely to be heaviest in equities versus the other funds in the plan. Something 40 years out could be 100% equities. That fund, that 2058 Target Date Fund can be your equity proxy even if you plan on retiring long before 2058. Then find the fund that has the nearest target date, maybe even targeting already being retired. That fund is likely to be 100% fixed income or have the vast majority in fixed income and can be the proxy for that asset class.

If you want an asset allocation of 65/35 equities/fixed income and the 2058 target date fund is 100% equity while the 2015 target date fund is 100% fixed income then you just split your 401k accordingly. If the funds are not 100% equity or fixed income, you just need to look through to see what they own and manage your exposures to each one accordingly.

I think target date funds are a wildly flawed choice but as is the case with many aspects of retirement and planning there are innovative ways to overcome setbacks or in this case, drawbacks.

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