You’ve been investing in your 401(k) for quite some time and are probably still clueless about where your money is going. (Don’t worry…you’re not alone)
But you’re thankful that they offer these “target date” or “life cycle” funds that make investing in your 401(k) so easy.
What are target date funds? You know… the funds where all you have to do is choose the year you plan on retiring and voila – you’re all set.
Winner, winner, chicken dinner…..how easy is that?
Here’s the BIG problem. Target date funds, although easy, can sometimes eat away at your returns.
Or stated just a bit more bluntly– They suck!
*You know I hate Target Date Mutual Funds when I take the time to record a video.
Target date funds were created to take away the hassle of having to research the mutual funds in your 401(k) and build and construct your own portfolio. But in my experience, taking the time to do the research and, essentially, build your own target date funds in your 401(k), is a much better option. It’s this “a la carte” approach that can potentially give you much higher returns over your working life.
What Makes Target Date Funds so Bad?
First, let’s understand how they work. Most often these funds are created by a specific mutual fund company. Then that mutual fund company will take 12-18 of their mutual funds and create this diversified portfolio on your behalf. As you age towards your “target date” of retirement, the 12-18 funds will start shifting to something more conservative (moving from fewer stocks to more bonds).
Sounds like a win-win, right? You would think. Here’s the problem…
When you start breaking down the individual mutual fund options inside these target date funds, you start to uncover that there are some or several of these funds that are just plum horrible.
What I’ve Seen With Target Date Funds
Over the years, I’ve seen countless target date mutual funds that my clients have brought in and thus far, I haven’t seen one that I’ve been impressed with.
Recently, I had three different clients bring in their 401(k)s, all of which have target date funds.
The common theme was…..you guessed it…. they suck.
Show Me Some Examples
Here are some examples of three clients’ 401(k)s where we compared the target date portfolio and looked at their ten-year returns, we adjusted that for inflation, and see how that compared with the new portfolio.
Now, keep in mind, that the new portfolio consisted of the mutual fund options that were available to them in their 401(k).
See, whenever you have a 401(k), the target date fund is usually the easiest option, and sometimes your default option, but you typically have the ability to go in and create your own portfolio. Most people don’t because they simply just don’t know and don’t feel comfortable doing it.
I can’t blame people for not feeling comfortable or qualified to do so. I’m hoping by showing you some numbers below that you’ll at least consider it. Let’s take a look…
Sample Client One
With each client, we kept the ratio of stocks and bonds relatively the same. As you can see, the first portfolio netted a 3.61% more return over a 10-year period. 3.61%! Remember, we are just using other mutual funds that are already in the 401(k).
| Portfolio | 10Yr Return | Adjusted for Inflation Assumed(3.4%) | 10Yr Beta |
|---|---|---|---|
| Target Date Portfolio | 4.22% | .79% | .90 |
| New Portfolio | 7.83% | 4.28% | .76 |
| Difference | +3.61% | +3.49% | -.14 |
For the super analytical people, I had to include other factors such as beta, standard deviation, and alpha. If you don’t know what that means, it’s OK. You don’t need to. What you may be more interested in is dollars.
| Portfolio | 10Yr Standard Deviation | 10Yr Alpha |
|---|---|---|
| Target Date Portfolio | 14.83 | 1.33 |
| New Portfolio | 12.80 | 4.79 |
| Difference | -2.03 | +3.46 |
What does 3.61% really mean over the long term? Well, let’s just say… A LOT. As you can see below, in 5 years on a $100,000 portfolio, it’s over $22,000. Wow! And as you can see it only gets bigger and BIGGER….
| Portfolio of $100,000 | 5YR | 10YR | 20YR |
|---|---|---|---|
| Target Date Portfolio | $122,958 | $151,186 | $228,571 |
| New Portfolio | $145,780 | $212,518 | $451,640 |
| Difference | $22,822 | $61,332 | $223,0069 |
Those numbers don’t really reflect what happens in a 401(k). If you have a 401(k), then most likely you’re adding to it on a per-paycheck basis.
Using the same returns, I wanted to demonstrate if you were adding $5,000 per year into it. As you can see the 20-year number is a $295,000 difference. Okay, that deserves a special call-out…
Still, think you’re target date fund is good enough for your retirement?
| Portfolio of $100,000 with $5,000 per yr contribution | 5YR | 10YR | 20YR |
|---|---|---|---|
| Target Date Portfolio | $150,159 | $211,832 | $380,907 |
| New Portfolio | $175,014 | $284,369 | $676,186 |
| Difference | $24,855 | $72,537 | $295,279 |
Sample Client Two
You can go through the rest of the examples and see more of the same. What’s the recurring theme? You guessed it. Target date funds suck.
| Portfolio | 10Yr Return | Adjusted for Inflation Assumed(3.4%) | 10Yr Beta |
|---|---|---|---|
| Target Date Portfolio | 7.00% | 3.48% | .69 |
| New Portfolio | 9.80% | 6.19% | .72 |
| Difference | +2.80% | +2.71% | +.03 |
| Portfolio | 10Yr Standard Deviation | 10Yr Alpha |
|---|---|---|
| Target Date Portfolio | 11.71 | 4.04 |
| New Portfolio | 12.57 | 6.66 |
| Difference | +.86 | +2.62 |
| Portfolio of $100,000 | 5YR | 10YR | 20YR |
|---|---|---|---|
| Target Date Portfolio | $140,255 | $196,715 | $386,968 |
| New Portfolio | $159,592 | $254,697 | $648,704 |
| Difference | $19,337 | $57,982 | $261,736 |
| Portfolio of $100,000 with $5,000 per yr contribution | 5YR | 10YR | 20YR |
|---|---|---|---|
| Target Date Portfolio | $169,009 | $265,797 | $591,945 |
| New Portfolio | $189,996 | $333,624 | $928,656 |
| Difference | $20,978 | $67,827 | $336,711 |
Sample Client Three
Different Client. Different 401(k). Different target date mutual funds. Same sucky results…
| Portfolio | 10Yr Return | Adjusted for Inflation Assumed(3.4%) | 10Yr Beta |
|---|---|---|---|
| Target Date Portfolio | 5.55% | 2.08% | .98 |
| New Portfolio | 7.78% | 4.26% | .89 |
| Difference | +2.23% | +2.18% | -.09 |
| Portfolio | 10Yr Standard Deviation | 10Yr Alpha |
|---|---|---|
| Target Date Portfolio | 15.96 | 2.59 |
| New Portfolio | 14.80 | 4.72 |
| Difference | -1.16 | +2.13 |
| Portfolio of $100,000 | 5YR | 10YR | 20YR |
|---|---|---|---|
| Target Date Portfolio | $131,006 | $171,626 | $294,554 |
| New Portfolio | $145,442 | $211,535 | $447,470 |
| Difference | $14,436 | $39,909 | $152,916 |
| Portfolio of $100,000 with $5,000 per yr contribution | 5YR | 10YR | 20YR |
|---|---|---|---|
| Target Date Portfolio | $158,939 | $236,153 | $469,828 |
| New Portfolio | $174,647 | $283,215 | $670,779 |
| Difference | $15,708 | $47,062 | $200,951 |
Managing Your Own 401(k)
Now, I understand that most people don’t know what the heck they’re looking at in their 401(k), so it’s hard for them to do their own research, but that’s where a financial planner comes into play.
Find an advisor who knows what they’re doing and have them construct an optimized 401(k) portfolio. Even if you have to pay that person $1000 to help with your 401(k), that $1000 is nothing, especially when you look at the numbers above.
401(k) Review Service
Since I realize people need help with their 401(k), it only made sense to include that as a part of my practice. Don’t worry, it’s not $1000. If you need help with your 401(k), check out my 401(k) review service.
Need help with your 401k?
If you’re struggling to make sense with your 401k, stop going at it alone. Read more about my 401k review service to get your retirement on track. Click here to learn more.
A financial planner telling everyone that a new development that makes it easier to manage a 401k without a financial planner actually sucks and that you really do need to pay a financial planner? Imagine my shock. TDF’s are great, if you put even a modicum of research into it and check in once or twice a year.
This is good info. Thanks for posting it. I have been trying to make sense of all the retirement saving/ investment options available out there. It is overwhelming.
Thanks Yana!
Interesting Blog. Thank you for sharing.
Target Date Funds are pretty controversial, but I think they are actually helpful for people who do not have a large sum to invest and want broad exposure to the market. If you have a 30+ year investing horizon and LOW FEES you cannot go wrong with a target fund in my unprofessional opinion.
I guess I should also add my view is that investing is not conventional anymore. You can’t simply “set it and forget it” like in decades past. Investing has to be much more diverse.
My strategy is to minimize taxes and preserve my capital by using the Target Fund as a (grows tax free) foundation and then supplementing, ETFs for a trend play, physical real estate (depreciation), currencies, and Precious Metals (untaxed appreciation). This way I have more diversity in my portfolio and can liquidate more easily if I need to.
I pay close attention to taxes and fees because at the end of the day the money you get out of these investments is AFTER paying the fees and taxes! Keep it Simple.
I am a portfolio manager for private clients and give investment advice, much like yourself. I have quickly read through your analysis as I came across it and have many issues with it. Target date funds have not been around for ten years, have they? Where are you pulling this performance info if it doesn’t exist? Regarding the individual funds available, 401(k) trustees are prone to the same behavioral biases as individual investors, they select funds based on past performance. So the funds available in 401(k)s tend to be the one’s that have performed the best in the past 3, 5, or 10 years. How many times do you get notices from clients that there are investment changes in their plan, I get them every week! The funds change. Also, how often are you rebalancing your individual funds’ portfolios? If you are not rebalancing and they become equity heavy, of course they will outperform a target date fund which becomes increasingly more conservative as time passes! A fairer comparison would be a rebalanced portfolio vs. strategic asset allocation funds that keep asset allocation more consistent across time. These are just a few… I am sure there are other issues. Although they are not the most ideal investments in the world, I don’t think it is fair to write off target date funds as poor investment choices. Each circumstance is different…
Precisely why i got OUT of these target date funds in my 401K, I was losing big time. To quote Mr. T.. ” I pity the fools” that stay in them.
They have no idea how much money they are losing.. Keep discussing this and help people understand.
Thanks Lynne!
great post. I am also an investment advisor and I totally agree with Jeff.
target date funds BLOW!
Hi Jeff, I’m a career Military Officer, and I was wondering what you thought about the government’s Thrift Savings Plan (TSP) and their target date funds. Thanks in advance.
Mark
Mark, thanks for stopping by the site.
When I was deployed to Iraq, I never participated in the TSP. I, instead, elected to focus both on my and my wife’s Roth IRA and paying down some pre-deployment debt.
Personally, I’m not a big fan of the TSP as I feel the investment options are very generic “C Fund, G fund, I fund, etc”. The target date funds are just an extension of those. I like the ability to having control in what I invest into; hence the Roth.
That being said, if I were a career officer and still had more money to invest on top of maxing out the Roth’s, I would probably still use the TSP. There’s no other tool that gives you the ability to sock away big chunks of money unless you are also self-employed. Once you officially retire, I would look to roll your TSP into an IRA so you now have control.
Btw, thank your for your continued service!
It’s pretty easy to set up a portfolio that beats any other portfolio for the last 10 years. It’s also pretty easy to cherry pick data from (I presume) a small subset of your clients to prove your point. Show us what these portfolios ACTUALLY return compared to each other in another 10 years and I might come around some.
Past performance does not equal future performance.
I agree with the “past performance does not equal future performance”.
Once again, I didn’t cherry pick the funds from a database of 30,000 mutual funds. I just picked what was available to them in their own plan.
As far as the clients I picked, they all just happened to come to me over the course of a two week period. When we started doing the analysis on them and realized how bad they were, I knew that I needed to do a post on it.
Target date funds are not for everyone, especially if they inhibit set it and forget it habits.
On side note, I love the videos. What camera and editing software do you use?
I have vforx at 0.18% expense ratio. I tried looking at etf equivalents but didn’t make sense going etf since some expense ratio especially international equities made the overall expense ratio higher than using the target retirement. The situation may be different later as my allocations change over time, but this is how it is looking. I was surprised myself thinking etf wiuld be better. What are your thoughts here?
@SunWKim Well, you just opened a can of worms with me 🙂
I can’t argue and say that cost/expense isn’t a concern, because it is. But it’s not the only metric. What about performance? Disclaimer: I’m not a big fan of passive investing or indexing.
Too often times I see people so focused on cost and not on return. For example, I had a recent prospect who loved Vanguard and his 0.15% expense ratio. When I showed him an active fund strategy that had fees in the 1.25-1.5%, he almost had a heart attack.
Even though by doing some back testing and demonstrating that the active portfolio returned over 3% more over the last 5 and 10 year period. And that is NET of all fees.
I’ll never say that my way is the only way as many passive investors make really good points and have data to back it up. I just life to offer a different perspective to make you aware that there are other options out there. Hope that helps.
@jeffrose Job security, I understand. I don’t think you can guarantee those rates like an index fund can not guarantee returns. At least with index funds, I can control my cost. That’s how I see it after reading this article years ago: http://www.modernluxury.com/san-francisco/story/the-best-investment-advice-youll-never-get
@SunWKim You’re right, I can’t guarantee those rates and never will.
What’s funny about the article I wrote (which I just realized) is that even the target date funds all out-peformed the SP 500.
Like I said, to each is to own, right? If controlling cost is your hot button, then that works for you.
@jeffrose I guess an interesting question and you don’t have to answer of course, is your track record for returns on active managing vs passive managing. What percentage of accounts you’ve generated more income for less your commission vs highly regarded index funds with low expense ratios. I’ve not read any articles on how often active managed portfolios beat index in the long haul – say 30 years or more.
@SunWKim What I have done is to create my own version of VFORX by taking advantage of the much lower expense ratios of ETFs AND Investor Class mutual funds. Most of the two of these have expense ratios of 0.07%. So I took my VFORX and split it into its components, with a few minor tweaks here and there, and any underlying fund that had greater than $10,000 in it got put in an Investor Class fund. Anything under that got put in the equivalent ETF. I lowered the expense ratio for the whole portfolio by greater than 50%.
@mitbeta @SunWKim Maybe you can explain how that works in more details? I noticed the international ETF equivalentand bond ETF equivalent is quite high. What is your expense ratio now? If you lowered from 2% to 1%, then it the expense ratio is 1% still, no?
@SunWKim @mitbeta Vanguard Total Bond Market Index Fund (VBMFX), from what I can tell, basically has the same investment approach and asset mix as the Vanguard Total Bond Market II Index Fund (VTBIX). The latter seems to be aimed specifically at institutional, rather than individual investors. The ETF (BND) and Admiral (VBTLX) Shares versions have expense ratios of 0.11%, instead of the 0.22% for the Investor class.
Vanguard Total International Stock Index Fund Investor Shares (VGTSX) has an expense ration of 0.26% and the ETF (VXUS) and Admiral (VTIAX) share equivalents are 0.20%. The 2% you saw is the redemption fee that only applies if the fund is held for less than 2 months, and doesn’t apply at all for the ETF version.
If you split the VGTSX into the funds that made up the international portion of VFORX prior to last year (when VGTSX was created instead…), you can bring that expense ratio down even further. My portfolio has instead:
Vanguard MSCI Europe ETF (VGK) 0.14%
Vanguard MSCI Pacific ETF (VPL) 0.14%
Vanguard MSCI Emerging Markets ETF (VWO) 0.22%
Granted, it’s more for the Emerging Markets ETF, but since that represents such a small overall portion of my portfolio, the total cost is lower.
@mitbeta Hi, thanks for your explanation… this helps a lot. For me, assuming I had $100k, 0.18% vs 0.14% is a $40 difference per year. $40 is arguably worth it for set-it-and-forget-it. I had a medical emergency, so I had to restart my retirement account… so the difference is not worth the hassle, but I can see it making a difference if we’re talking millions in the IRA.
Great examples! I like this kind of analytical detail. I have been skeptical for a long time of target-date funds. For the past 10 years, I’ve seen a lot of publicity about them. “They’re easy” “Just set them and forget them”. But is that what we really want for our retirement savings? Nothing comes easy. And investing seems like it should be a little more active than that. I’ve had a lot of other funds that were cheaper and better performers. I agree it’s better to sit at the big table and leave the target date funds behind.
I have a Target Fund for my retirement Roth IRA which I have started and maxed out for the past three years (and hopefully continue to do so). I also have a 10 yr Mutual Fund Target Fund. I set these up for the same reasons you explained. It probably is 80% best, but eliminates a lot of hassles and stress and I do not have the ability to make these decisions on my own right now. It is an eye opener though. To be honest, I can’t tell you what’s in either account. I need to take some time to dive into it deeper, and learn how to may pick a few in there.
@CraigKessler That’s typically what I hear from a lot of people. They don’t get it and assume they are in good hands. As you can see, too much time can cost you and cost you BIG. It’s time to dig a little deeper. 🙂