Addressing Allegations: Are TDFs Costly and Inefficient?
I've been asked why I include Target-Date Funds (TDFs) in my investing strategy as some contend they are inefficient, costly, and inappropriate for long-term retirement accounts. Let's explore those allegations, and why I believe otherwise. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
My PDQ Rant
Before launching into a complicated discourse about Target-Date Funds, I'd like to lay my out my savings/investment philosphy as it serves as a platform for why I like the darn things. Let me reiterate that it's unfortunate that America’s secondary schools offer their students almost no exposure to personal finance instruction of any sort, much less to the intricacies of saving and investing. But an individual has to start somewhere. I'll start with my PDQ investing principles and then take it from there...
My PDQ Principles of investing = Patience, Diversification, and Quality. Here's how they work:
Determine your specific savings objectives (big wedding, new home, baby, retirement, etc.).
Create a Rainy Day fund
Buy a low-cost, good QUALITY, highly DIVERSIFED index fund around which to build your portfolio.
Exercise patience (ignore the herd) as your portfolio grows.
By the way, that patience factor is becoming more important as the market grows increasingly antsy in today’s inflationary and politically-confusing, virus-sensitive environment. In any event, my PDQ approach should help reduce your risk as you become more experienced as an investor.
Out of Sight...
Many investors tend to be uninterested in and/or unschooled about investing…and for those reasons, naturally tend to be “set it and forget it” types, such as with their 401(k) accounts. They decide on a particular set of investments offered by their employers’ plans, make the commitment, and seldom revisit their portfolios.
This is where Target Date Funds come in. A TDF is an investment fund that automatically changes your investments from high-risk, high-reward to low-risk, low-reward holdings as you near retirement. Investors are able to purchase TDFs and then forget about them if they are so inclined. These all-in-one funds offer a mix of domestic and international stock and bond funds, often with inflation-protected securities thrown in early on, to round out the portfolio – a highly diversified package of assets with that important reallocation feature.
So, Why TDFs?
The reason I like TDFs is that they rebalance periodically…a highly-recommended activity that too few investors would NOT DO if left to themselves. In theory, an investor’s intermittently-rebalanced portfolio becomes less risky as they approach retirement.
TDFs offer a diversified portfolio within a single fund that adjusts its underlying asset mix over time. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund.
An added TDF benefit is that portfolios left alone by investors tend to outperform those managed by the traders among us. As to cost, the annual expense ratios assessed by Vanguard Target Retirement Funds, America’s largest TDF provider, typically range from about 0.12% to .15%. And TDFs are no more exposed to capital gains taxes than other funds (and not exposed at all for folks who buy TDFs in their Roth 401(k) or Roth IRA accounts).
TDFs and the 401(k) Default
Increasingly, TDFs are available in IRA, 401(k), and 403(b) accounts or in personal non-retirement accounts. And, if you weren't aware, employers are now allowed to automatically enroll new employees into 401(k) plans with qualified “default” investments (such as TDFs). On principle, I have no problem with default plans. In fact, I think they’re good because studies show that once enrolled in a 401(k), most people opt to stay. In short, more folks are investing in 401(k)s for retirement purposes than in past years.
And, since the massive shift from defined benefits to defined contribution retirement plans in recent years, several important changes have been made to the latter plans in addition to the aforementioned employer “default” capability that have increased employee savings, improved investment performance, and reduced cost. In my mind, at the top of that list of positive changes is the inclusion of TDFs among an employee’s list of investment choices to buy.
But what if you are a 401(k) program participant who doesn't fit the usual criteria? Say, you want to do more than set it and forget it? There are other TDF options for individuals who have a high net worth or who have other sources of income to rely on during retirement (pensions, annuities, etc.)…or folks who might have higher discretionary spending goals in retirement and the financial means (and the temperament) to withstand greater periods of volatility in the equity markets.
Vanguard’s new Target Retirement Income and Growth Trust, with its 50% equity allocation, is an alternative TDF option for you. Under this plan, those who are already invested in the Target Retirement Trusts would be offered the choice as they approach age 65 to opt into the new strategy, freezing their more risky equity allocation at 50%. Participants who choose not to opt in would continue on the current glide path (eventually transitioning to the normal strategy of 30% equity around age 72). Except for the divergence in asset allocation after age 65, both strategies offer identical expense ratios, underlying funds, and management approach.
(And, no, I'm not a Vanguard "influencer" - I just like 'em. Other companies offer similar investment opportunities.)
Remember: Too quick a brush with the facts (about anything) is potentially a risky undertaking. Wisdom gained through experience, too, has its pitfalls and should be applied with great care. Do your research before investing in anything.