Why Target Date Funds Are a Poor Investment Choice

Target date funds (TDFs) have become a popular choice for investors, particularly within employer-sponsored retirement plans, due to their perceived simplicity and automated management. These funds offer a diversified portfolio of investments that automatically adjust asset allocation over time. The concept promises a “set-it-and-forget-it” approach, appealing to those who prefer a hands-off investment strategy. However, despite their convenience, TDFs possess characteristics that may render them less than ideal for every investor. This examination will delve into specific aspects of TDFs that warrant a more critical view.

Generic Investment Strategy

Target date funds are built around a “glide path,” a predetermined strategy that shifts asset allocation from more aggressive to more conservative as the target retirement date approaches. This path is designed for a hypothetical “average” investor, assuming a standardized financial timeline and risk tolerance. For example, a fund might start with a high allocation to equities and gradually reduce it, increasing bond exposure as the target year nears.

This standardized approach often fails to account for the unique financial situations and preferences of individual investors. Some investors may be comfortable with more aggressive growth strategies even closer to retirement, while others may prefer greater capital preservation earlier on. A TDF’s fixed glide path cannot adapt to these personal differences, potentially leading to a portfolio that is either too conservative or too risky. Furthermore, these funds do not consider an investor’s other assets, income streams, debt situations, or specific financial goals like saving for a child’s education or a significant planned purchase.

Cost and Tax Efficiency

Target date funds involve a cost structure that can impact long-term returns, primarily through expense ratios. An expense ratio is an annual fee, expressed as a percentage of your investment, that goes towards the fund’s operational expenses. While seemingly small, these fees, when compounded over decades, can significantly erode investment returns. For instance, the average asset-weighted expense ratio for target date funds was approximately 0.36% at the end of 2023.

Many TDFs are structured as “funds of funds,” meaning they invest in a portfolio of underlying mutual funds or ETFs. This structure can lead to layered fees, where investors pay the expense ratio of the TDF itself, in addition to a proportional share of the fees charged by the underlying investments. Even if a TDF’s stated expense ratio incorporates underlying fund fees, the total cost burden requires careful consideration.

Beyond direct costs, target date funds can present tax inefficiencies, particularly when held in taxable investment accounts rather than tax-advantaged accounts like 401(k)s or IRAs. The fund’s internal rebalancing activities, which involve selling and buying securities to maintain the predetermined asset allocation, can generate capital gains distributions. These distributions are typically passed on to investors, becoming taxable income even if the investor has not sold any shares of the TDF. Depending on how long the underlying securities were held, these distributions can be taxed as short-term capital gains (at ordinary income rates) or long-term capital gains (at more favorable rates). This contrasts with direct investments, where an investor has more control over the timing of sales for tax planning purposes.

Asset Allocation and Market Volatility

Target date funds’ predetermined asset allocation automatically shifts from aggressive investments, primarily equities, to conservative ones, such as bonds, as the target date approaches, aiming to reduce risk as retirement nears. However, this automatic shift may not always align with optimal market conditions or an investor’s actual risk capacity throughout their life. For example, being heavily allocated to bonds during periods of low interest rates can lead to lower real returns, as bond yields may not keep pace with inflation. Conversely, shifting too conservatively too early in an investor’s career could limit the potential for significant growth, especially during extended bull markets.

The specific composition of a TDF’s underlying assets can also expose investors to unexpected risks or limit upside potential. While TDFs generally diversify across asset classes, the mix of domestic versus international equities, or the types of bonds included, can vary significantly between funds. Some TDFs may have substantial allocations to international equities that have historically underperformed domestic markets, potentially dragging down overall returns. Additionally, while TDFs generally aim to provide inflation protection, some rely heavily on Treasury Inflation-Protected Securities (TIPS), which may offer relief but can also result in lower income compared to other bonds.

The automatic rebalancing and fixed glide path remove the investor’s ability to make tactical adjustments in response to market opportunities or downturns. During market volatility, a TDF’s automatic rebalancing might sell well-performing assets or buy declining ones. This lack of flexibility can disadvantage investors who prefer a more active management approach, potentially leading to suboptimal outcomes.