Target-date funds: a little too easy

An increasingly popular feature in retirement savings is the target-date fund – a portfolio that automatically shifts its allocation away from stocks and into bonds according to a predetermined schedule. The idea is for it to incrementally dial down the risk (and expected rate of return) as you age closer to retirement, all without you lifting a finger.

Pretty neat, right? Well… yes and no. TDFs are certainly convenient, making them a great fit for some investors. But convenience always comes with a price; and I suspect many TDF users are not aware of what that price is.

Fees within fees… within fees?

Mutual funds and ETFs always come with an expense ratio, or a percentage of the account balance that is charged as an administrative fee. Perfectly reasonable; but in the case of TDFs, the expense ratio you see on paper may not reflect how much you actually pay.

This is because TDFs often (though not always) consist of slices of other funds, which themselves may contain little slices of still other funds. However far down this Russian nesting doll goes, each fund within it will have its own expense ratio.

To be fair, this is not as much of a problem as it was 10 or 15 years ago. Expense ratios for many TDFs have gotten extremely low, so even a bunch of them bundled together can be pretty affordable. The trick is to do your homework so you know exactly what you are dealing with.

The Rule of 100

The bigger problem is that TDFs are based on the same logic as the (highly unreliable) Rule of 100. As you may remember from a couple months ago, the Rule of 100 rests on two problematic assumptions:

  1. That most retirement-savers should have their portfolio become less aggressive as they draw closer to retirement; and
  2. That bonds are inherently safer – i.e., less aggressive – than stocks.

TDFs follow this rule by increasing the proportion of bonds in your portfolio as you age. This is far from a foolproof strategy, however. For one thing, there are plenty of people who cannot afford to invest more conservatively simply because they have reached a certain age. For another, it is simply not true that bonds are always the most conservative option.

To sum up

Despite these flaws, TDFs still have their uses. They are a great “set-it-and-forget-it” solution for those who prefer not to fuss with fine-tuning their expense ratio or total return potential. They could alsobe a good choice if you want to minimize fees. Just make sure those “nested” expense ratios do not add up to more than you can afford.

So in short, if you want long-term convenience and affordability – and are willing to do a bit of homework beforehand – TDFs are definitely worth looking into. But if you want something more flexible, and/or want to keep your fees as straightforward as possible, then you should probably look elsewhere.