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Are Target Date Mutual Funds Right for You?

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An article from my friend, Jeff Rose caught my attention recently: Why I Hate Target Date Mutual Funds and You Should, Too. The title caught my attention - hate is a strong word that I haven't seen Rose use too often.

For those who aren't aware, target date mutual funds are typically designed to start out with more aggressive investments (stocks) and gradually get more conservative towards, well, the target date. The philosophy is that want to take the risks and reach for those high rewards at the beginning of your career, but as you get close to retirement, you want to preserve the nest egg. One of the biggest advantages is that you can "set it and forget it" (please don't sue me Ron Popeil) - you can't have to manage the portfolio, it manages itself.

The Good Financial Cents article, which I'll get to in a minute, reminded me of my own story regarding target date mutual funds. A representative from USAA called my wife to make sure her investment objectives were being met. He suggested one of USAA's target date mutual funds. I asked him why go with USAA when Vanguard and Fidelity's have lower expense ratios. He didn't have good answer for that other than USAA was charging a substantial fee (if memory serves) to get into those mutual funds. Long story short, we went some Vanguard ETFs based around index funds that had low commissions. This do-it-yourself wasn't exactly what I was looking for, but it was the best use of money.

When I saw Jeff Rose's article about hating target date mutual funds, I expected to read about how the funds have two sets of fees. There are the fees that the individual funds have, and the fees for managing/re-balancing the portfolio of mutual funds. He did get to that, but he uncovered something else. Some of the mutual funds included in these target date funds are, in his words, "just plum horrible." (Side Note: Kudos to him for the use of plum as an adjective.)

Rose gives some examples of target date funds in some of his clients' 401k plans and shows with back-testing that he could have made the client more than 3.5% with other choices in the 401k plan. Using the magic of compound interest Rose shows that in 20 years, that difference could be $295,000. Yep, that's number is not a typo. We should all hate target date mutual funds right?

Maybe not so fast...

Here are a couple of thoughts that I had that may change your mind:

  • In 401k plans, there are limited investing options. Perhaps the target date mutual fund option in these clients had bad stocks, but I think it is a stretch to say that they are ALL bad. Outside of a 401k plan you may find a good target date mutual fund.
  • The 3.5% increase in returns in the examples are based on back testing a portfolio over the last ten years. Hindsight is 20/20. It's easy to say that you should been in Legg Mason Value Trust when Bill Miller was beating the S&P 500 year after year... until it got decimated in 2008 (even in comparison to the market). Haven't we read that past performance is not indicative of future results?

In the end, I realized that Rose's views are different than mine. He's into actively managing funds. I used to be that way, but I've settled into the low-expense index ratio camp. I haven't been able to find that active advisor who is going to guarantee me that they'll beat a broad index by 3.5% year after year, so stick with what I can control and that's the fees.

Posted on February 2, 2012.

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4 Responses to “Are Target Date Mutual Funds Right for You?”

  1. I’m invested in a target date fund with my 401(k).

    My employer picks up all the fees related to the 401(k) but does pass along a fee related to the target date funds. That fee is about .02%. So if I would generally get an 8% yield from the investments, I’d get 7.98% instead.

  2. Jeff Rose says:

    Yes! I love a good rebuttal. :)

    You make a good point that I didn’t address, was the two layers of fees. That is another reason why I’m not a big fan (HATE) target date funds.

    In regards to the examples I showed, all of those clients 401k’s only had actively managed funds. (If they did have an index if was just the SP 500 and the bond index) but that’s it.

    The hope or intent was to demonstrate to not settle for the default option that your company places you into. Do some research and make sure there aren’t better options.

    As far as your “controlling the fee” point, I think that’s a valid argument and it’s one that I hear often.

    Parts of me sometimes wishes to just become a Boglehead and convert to an indexer. But I’ve exposed to too many funds that have consistently beaten their index for the past several years. Maybe their easier to find since I’m a financial advisor and are exposed to them? I’m not sure.

    I think one thing that we CAN agree on is, no matter what you do….just invest!

  3. Luke says:

    What happened to the comments?

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