What is a Target Date Fund and Should you Invest in One for Retirement?
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If I was going to invest my money in a target date mutual fund, I would look for the lowest cost one that I could find that matches up with my retirement date, my retirement goals, and my tolerance for risk.

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today, well, today I have to be honest, I'm missing my two boys today. I've been on the road for almost two weeks now, and it's officially the longest I've ever been away from them. I was out in Washington, DC speaking at a conference for a few days, and then my wife was super nice and

She flew out there without the kids and she joined me halfway through. And then we spent some time touring around DC because we had never been there before. We'd never been to Washington DC. So we decided let's spend a few extra days there and check it out. So we had a blast. Now I'm in Denver with some of the top financial planners in the country. And we're learning from some really talented people.

how we can better help and serve our clients and help them plan for retirement. So I finally head home tomorrow evening and I'm really excited to see my kids and give them a big hug.

Anyhow, okay, with the sappy stuff out of the way, thanks to a very thoughtful email from a listener of ours in Manchester, New Hampshire. Today, we're going to cover just about everything you've ever wanted to know about target date mutual funds. And I'm not going to waste any time doing this. It's this simple. If you are investing your money for retirement, you have probably come across target date funds, which means this episode is for you.

For all the links and resources mentioned in this episode, go to youstaywealthy.com forward slash 53. Okay, so let's start with the basics. What exactly is a target date retirement fund? If you've ever seen a mutual fund with a year in its name, that is a target date fund. For example, the Vanguard Target Retirement 2025 Fund, that is a target date fund.

the year listed in the name of the fund, in this case 2025, indicates the year that you plan to retire. So if you plan to retire in or around the year 2025, you might invest your money in this mutual fund. Maybe you're retiring next year. In that case, you might choose a 2020 target date fund instead.

These mutual funds are usually offered in five-year increments, 2020, 2025, 2030, and so on. And they're essentially what some might call asset allocation mutual funds, meaning you buy this one fund and it does all the asset allocation work for you by investing in a basket of other mutual funds in order to achieve its investment objectives. It's one fund.

fund, one ticker and one solution. So instead of buying 10 different mutual funds with 10 different ticker symbols and trying to manage those different positions and rebalance them, you can just put all your money into one target date fund that matches up with your retirement goals and then let the fund do all the work for you.

Now, the underlying investment strategy, at least just from a very high level, is pretty simple. Since the 2020 fund indicates that you will be retiring in 2020, it's going to be or it should be more conservatively positioned than, let's say, the 2030 fund. And the 2030 fund should be more conservative than the 2040 fund.

These mutual funds that you invest in, these target date funds are constantly being rebalanced. So as you get closer to the target date, the fund is getting more and more conservative. The fund is essentially moving from stocks to bonds automatically, very, very, very slowly as you approach your target retirement date so that when you retire, most of your money is in bonds and cash instead of risky stuff like stocks, which is

probably make sense to everybody listening to this. If you have ever participated in a 401k plan at work, you might've wondered why there are always target date fund or usually there are target date fund options inside the plan. You might have even been automatically enrolled and invested in a target date fund without ever choosing one. Why is that? Here's the deal.

Back in 2006, there was something called the Pension Protection Act of 2006. And all you really need to know is it encouraged employers to adopt automatic enrollment features for their 401k plans by introducing something called Qualified Default Investment Alternatives. The short code for this is QDIA, Qualified Default Investment Alternatives.

And they did this because a lot of people, and maybe you're one of them, would enroll in these 401k plans. They would contribute money to them, but then they would fail to choose an investment mix. Maybe they forgot. Maybe they didn't realize that even once they contributed, they needed to go in there and then invest the money. For whatever reason, a lot of participants would contribute and then the money would just sit there. The

The contributions would sit there in cash, which we all know is not a good thing when we're saving for a long-term goal like retirement.

And so some argued that this could be the employer's fault for not educating their employees and teaching them how and where to invest their hard-earned contributions, hence the introduction of QDIAs, these Qualified Default Investment Alternatives. So now today in many pension plans, if you fail to choose an investment option or an investment mix for your 401k, you're

your contributions will be automatically invested for you in the QDIA that your employer selected. And oftentimes the QDIA is a target date mutual fund. There are some other QDIA options that employers can choose from, but the target date funds are overwhelmingly the favored QDIA choice among fiduciaries. So that's why you might see them in your 401k plan. And that's why you might have been automatically enrolled in one.

To help kind of further shed some additional light on automatic enrollments and target date funds, I went ahead and I asked Aaron Potashin with Alliant Retirement Consulting. This is all he does. He's the 401k expert. And I just asked him to come in really quick and share a few short comments with us. Hey, this is Aaron Potashin with Alliant Retirement Consulting.

When it comes to target date funds, I think a couple of things that participants should keep in mind is that number one, a company has defaulted you into this fund, believing it that it is the right investment for you. Now, one of the things that a company doesn't know is they don't know what assets you have outside of the 401k at that employer. They don't know if there's any inheritance in your future. They don't know what your real estate holdings are or what have you. So

understand that a company has made this determination knowing only one thing about you, which is your date of birth and assuming that you're going to retire at a certain age in the future. So I think it's important to understand that when you're defaulted into those funds, that might not actually be the right allocation for you. And the best way to make sure that it is, is to engage in a process, whether that be with a financial advisor or utilizing some other service to understand what's the right allocation for you.

And by utilizing those other outside services, again, whether it's through a financial advisor or through another service to understand what your proper risk allocation should be, only then will you know of

that target date fund that you were defaulted into is actually the appropriate one for you. So we always recommend, while it might be a good asset for most people to utilize in the 401k, for many people, it might not be the ideal allocation they need. So again, if you're already an employee that was defaulted into a target date fund, there's a good chance that it is the right one for you, but it might not be. The best way to check it, make sure it is,

Engage a financial advisor, preferably somebody that's a CFP or a fiduciary, and or utilize a tool that will help you understand what's the right allocation for you based off your age right now. Thanks so much. It's important to note that you don't have to be participating in a 401k plan to invest in target date funds. Just about every custodian that you know by name, Vanguard, Fidelity, Schwab, TD Ameritrade,

They offer target date mutual funds on their platform that you can invest in inside your brokerage account or IRA or whatever type of account, your trust account, whatever you might have there. And just like every fund company, every mutual fund company that you know has a U.S. large cap stock fund,

a lot of these fund companies also have their own version of target date funds. So American Funds, T. Rowe Price, Vanguard, Fidelity, JP Morgan, the list goes on. All of these fund companies, they all have, or most of them have, a 2020 fund, a 2025 fund, a 2030 fund, etc. They all have their own version of target date funds.

When you're researching these target date funds, either inside your 401k at work or on your own through your custodian, you might notice that some are active strategies and some are index-based or passive strategies.

Active target date funds are going to invest in a basket of actively managed mutual funds that are attempting to beat the market by actively trading stocks and bonds. And then the passive or index-based target funds are exactly what you might think. They're going to invest in a basket of low-cost index funds that are attempting to track an index.

Sometimes it's hard to tell, is this an active target date fund or is this a passive index-based target fund? And what I've found is the easiest way to tell is simply by looking at the expense ratio of the fund. And I've mentioned this in previous episodes. You can go to Morningstar.com and just type in the ticker symbol of any fund or any ETF or any stock, and you can find the expense ratio right there front and center for free.

So the easiest way to tell, in my opinion, to see if something's active or passive is to look at the expense ratio. And the expense ratio tells you how much you're paying that mutual fund company to invest your money for you.

actively managed target date funds are typically going to be more expensive and have a higher expense ratio than passively managed target date funds because you're paying managers to actively trade stocks day in and day out to try and beat the market. So there's some added levels of complexity there. There's more people, more staff. It's just more expensive. So you're usually going to see if you're comparing side by side that the active target

target date funds are going to be more expensive than the passively managed or indexed target date funds. And as you guys have heard me say on this podcast more times than I can count, the expense ratio of an investment is one of the most important things that I think you should look at before putting your money inside of an investment. And this is even more true for target date mutual funds because

Let's just put aside this active versus passive conversation for a moment because target date funds are all-in-one solutions. They do a lot of the heavy lifting for you. They're moving from stocks to bonds automatically as you get closer to retirement.

So because there's some added work in there, because they're doing this heavy lifting for you, again, put aside active and passive for a moment. Target date funds inherently, they're just going to be more expensive than if you piece together your own portfolio and you rebalanced it on your own and you did all the work yourself. So target date funds inherently are going to be more expensive anyways. Now, if you choose an actively managed target date fund,

that's gonna add another layer of fees on top of that, making it even more expensive. So you really need to pay attention to the cost of these funds because they're already a little bit more expensive. And then if you choose the active strategy, it's gonna be even more expensive.

Most of you know, I personally don't believe that it's possible to consistently beat the broad market indexes year over year over year through expensive, active strategies. And therefore, if I was going to invest my money in a target date mutual fund, I would look for the lowest cost one that I could find that matches up with my retirement date, my retirement goals, and my tolerance for risk.

I always like to, you've probably heard me say this, I always like to remind listeners of the academic study published by Vanguard that concludes that the best predictor for future investment returns is the underlying expense of that investment. In other words, lower cost funds or lower cost investments have a higher expected return than higher cost investments.

And I also like to just add that it's not that active fund managers or these mutual fund managers or hedge fund managers, it's not that they're bad stock pickers or they aren't smart people or anything like that. It's usually that the fees that they charge erode any sort of alpha that they might add to the portfolio, which is...

essentially why Vanguard kind of came to that conclusion is fees are one of the best predictors of future returns. I've done it before, but I will link to that Vanguard study again in the show notes if you're interested in diving in. Again, you can find the show notes at youstaywealthy.com.

forward slash 53. Okay. Now you might be scratching your head a little up to this point and saying, wait a second. If all these fund companies have their own version of let's say a 2030 target date fund, then like, wouldn't they all just be the same? Why would a, why would a 2030 fund be any different at Vanguard than it would be at let's say Fidelity or American funds?

And this is the million dollar question right here. This is a great question. Unfortunately, every target date fund is different, right? We don't make anything easy in the financial planning space. So every target date fund is different. You could line up five different 2030 target date funds from five different fund providers, and they could all look very different once you open up the hood.

They're going to look different today, and then they're also going to look different when they reach their target year. So their asset allocation changes that they're making day over day or year over year are going to look different at the end.

Some might have more stocks and bonds. Some might have a larger allocation to international stocks. Some might include REITs in the portfolio. Some might not. Some might own junk bonds or emerging markets. What's even scarier is that some of these target date funds might still have a relatively large allocation to risky stuff like stocks, even when you're getting close to retirement.

one fund company's version of conservative might be different than the others. And this is why it's so important to do your homework before you put all of your hard-earned money in a target date fund, just because it's a convenient one fund investment solution that happens to have in its name the year in which you plan to retire. Remember, the last few years heading into retirement,

And the first few years after you actually retire, in my opinion, represent the most vulnerable time for your money and your investments. So it is critical that you understand exactly how your money is being invested today and also that target year. And you can't just rely on the name of the mutual fund that has that target year in the name of it for the year you plan to retire.

So as you guys know that this podcast is purely for informational and educational purposes only, there's no recommendations in here, but if I were to invest in a target date fund, these are the four things that I would personally look at. Number one, the expense ratio. We covered that.

If possible, I would try to find a target date fund with an expense ratio less than 25 basis points or 0.25%. So go to Morningstar.com, punch in that ticker symbol, and that's what I would look for. Number two, I would look at the asset allocation of that target date fund today. So every mutual fund can be looked up online through the fund provider, and they'll show you all the positions and exactly how it's allocated today.

So let's just say I'm looking at retiring in 2030 and I'm considering the Vanguard 2030 target date retirement fund. Well, 2030 is a long ways away. It's over 10 years away, which for me allows me to take some risk with my investments. Personally, I would want to see a lot more stocks than bonds in my 2030 target date fund because that's

it's over a decade before I actually go and retire. We know 10 years is a long time. Yes, we've had some lost decades and things like that, but it's a long time. I want to take some risk. So it would be good for me to know exactly what the asset allocation of that target date fund is today. Again, the Vanguard 2030 fund, once I open up the hood, might look different than the Fidelity 2030 fund. So I want to open up that hood and see how it's allocated today.

Also, I personally like to see a large chunk of my stock position invested in international stocks. So sometimes when you look inside these target date funds, they might tend to favor US stocks really, really heavily. This is called having a home bias. And I would want to know that before I put my money in there.

Okay, number three, along with knowing how the funds allocated today, I would want to know what the fund allocation might look like the year that I retire. So let's say that I'm still considering that Vanguard 2030 target date fund.

I think it would be a helpful exercise for me to look under the hood of the Vanguard 2020 target date fund to give me an idea of what my asset allocation of the 2030 fund might look like 10 years from now. Now, Vanguard might make some changes between now and 10 years, so this isn't perfect. But if I want to get an idea of what my 2030 fund might look like in 10 years...

I'd like to open up and look at the Vanguard 2020 fund. So I actually did some quick research today and the Vanguard 2020 fund, remember this is for people retiring in 2020. That fund still has about 51% invested in stocks. Now, if I'm retiring in 2020 next year, like six months away or five months away,

I'm not so sure I want 51% of my money invested in stocks as I head into one of the most vulnerable periods of my financial life. This has nothing to do with market valuations or where I think the market's going, nothing to do with that, but it's a really vulnerable time in my life. I

I'm just not sure that I want 51% of my money invested in stocks as I head into retirement. So that's good information for me to take into consideration. Now, maybe you have a different feeling. Either way, I just think it's good information to have in your pocket before you put money into these target date funds.

And then lastly, number four, I would like to take into consideration and understand what other investment options are available to me. If I'm investing inside of a 401k plan at work, I'm likely very limited to what I can invest in. So the other investment options inside of my 401k plan at work, not.

Maybe they're more expensive and more active than I would personally prefer. And maybe that target date fund, although it's not perfect, maybe it's the lesser of two evils. So I might choose it because of that.

Or I might be investing in my own IRA or brokerage account through one of those big custodians. And maybe I have access to all these super low cost index funds and target date funds aren't looking that great anymore. And on top of that, I might want more control over my asset allocation. So

it'd be good to know what other options I have available to me before I just plow on my retirement savings into a target date fund. So I'm not saying that this should sway you one way or the other. I just think these are like the four main things that I would take into consideration before doing this. Weigh all of your options before you determine whether this is a good option for you or not.

So with all of that out of the way, assuming that someone has access to a set of high quality, low cost target date funds,

I'll try to answer this question. Why might they choose this option? And I think the main reason for choosing a target date fund is really to take the heavy lifting off your shoulders. They certainly aren't perfect. We could pick them apart. We could find problems with them, but they're usually better than the average consumer trying to build and manage their own portfolio, especially when you're stuck inside of a 401k plan and you've got very limited and sometimes expensive investment options.

A target date fund allows you to focus on making money and saving money while leaving this nerdy asset allocation work to the target date fund and the fund company.

Also, if you just know this about yourself, that you are the type of investor that often gets in your own way. Maybe you're buying and selling based on your emotions. You're letting daily headlines get in the way of your investments. Or maybe it's the opposite. Maybe you neglect your portfolio because you're just so busy doing other things like working and making money and hanging out with your family and traveling. Maybe you neglect your portfolio for those reasons.

A target date fund might just be an easy, low cost way to just take yourself out of the picture and put it on autopilot so you can focus on the things that are most important to you and outsource those responsibilities. And then lastly, as I already mentioned, you might choose a target date fund because maybe it's just the best option available to you. Maybe it's the lesser of all the other evils that you have access to. And that's why you choose it.

All right, try to bring us home here. Because our awesome listener in New Hampshire was so kind to send over all of his thoughtful comments and questions on target date funds and was the inspiration for today's episode, I just want to make sure that I got all of his questions answered. So he had asked about investing in more than one target date fund and laddering them by buying a little bit of each. Maybe you buy a little bit of the 2030 fund, a little bit of the 2040 and some of the 2050.

He also mentioned, well, what if I used a target date fund as maybe my core position for a large chunk of my money? And then I stacked some individual investments kind of on top of that to get exposure to more specific areas.

So he's wondering, is this a good idea to buy more than one of them or kind of make it a piece of the portfolio? And the first thing I just want to say is, well, number one, it's a great question. So thank you for asking. But number two, there is such thing as over diversification. It is really important to make sure you're not buying a bunch of things that are doing the same thing because that can add

added complexity, an extra layer of fees, taxes can come into play there. So there is such thing as over diversification. And I think our guest that made some comments earlier, Aaron, our 401k expert, he mentioned, you should have a global asset allocation for your entire financial plan. Maybe you're considering this target date fund or a few of these target date funds inside of your 401k.

But what do you have outside of your 401k? What do you have in your IRAs and your taxable accounts, your trust accounts, all that stuff? You should have a global target for your asset allocation. And if you start there, then you can ask yourself, where might a target date fund fit into my global allocation for everything to make sure I don't have a bunch of things that are overlapping and just doing the same thing.

So really important to make sure that you're looking at everything and not just focus on making a decision for your 401k plan or whatever account you might be looking at.

Lastly, I could see how you could ladder target date funds and buy the 2030 fund and the 2040 fund and the 2050 fund, but only if you're using them to fund different goals. So maybe you have different retirement goals, or maybe you're using a 2040 fund because you're planning to use that chunk of money to

I don't know, invest in a business in 2040. These target date funds can be really popular in the college planning world. So maybe you're buying a fund for a grandchild or a child and they're going to go to school in 2030. And so you want to use a target date fund for them. So I think it's okay to buy a few different target date funds if they all each have their own goal.

but I can't seem to make sense out of just buying three different ones just because it feels like I'm extra diversified. That doesn't seem to really resonate with me. So I'm not sure why you would ladder them for that reason. I think you can get a little bit more intentional and smart about your allocation other than saying, I don't know what to do. So I'm going to buy three or four different target date funds and call it a day. I think that's probably not the best way to approach it. But if you have different goals that you're planning for, I think you can use different target date funds for different goals.

Okay, the other question that he asked that I haven't answered yet is how do target date funds perform over time? And this is a hard question to answer. I don't have all the historical data, but I did do some research and I found something kind of interesting over at Morningstar.com and I'll link to this article in the show notes. They did an article talking about the Yale Endowment Fund and the Yale Endowment Fund always comes up and they always talk about the returns of the Yale Endowment Fund that's managed by David Swenson.

And so there's this article I found that was talking about the 10-year period from mid-2008 to mid-2018, highlighting that the Yale endowment gained an annualized 7.4% rate of return. So, you know, not bad, pretty good.

But then it went on to say that during that same period, the three largest target date 2035 mutual funds from Vanguard, Fidelity, and T. Rowe Price, they returned during the same time period 7.3%, 6.7%, and 8% respectively.

And the point in this article was, you know, employees of these 401k plans that might have been defaulted or automatically invested into these target date mutual funds roughly kept pace with the nation's most popular endowment portfolio just by buying this simple target date fund. So it was kind of funny that these target date funds were being compared to, you know, one of the biggest and most popular endowments out there.

It went on to say that, and again, this is a 10-year period, so a really short time horizon, but it did go on to highlight that, yes, 7.3%, 7.4% annual rate of return is great, but during that same time period, the S&P 500...

had an annual rate of return of 10%. So these target date funds and even the Yale endowment underperformed just the plain old S&P 500 by almost 3%. Now, again, short time period, we could cherry pick time periods all day long and find little things like that. I just want to share that with you because as I was doing research for the show, trying to answer that question that came up.

I think just the last thing I'll say about historical performance is I wasn't able to find anything concrete for this is that I just go back to that, that Vanguard study that, that talks about, you know, expense ratios and, and, and fees. So I think really focusing on making sure that you're finding a target date fund, if that's what makes sense for you, finding it,

a low cost target date fund that achieves your goals. And I go back to that, that 25 basis point number. That's just kind of for myself. There's no nothing written in stone there, but if I could find a target date fund less than with an expense ratio, less than 25 basis points, I'm putting myself in a pretty good position for success. All

All right. His last question was, Hey, you know, my 401k is at fidelity, but my target date funds are through Vanguard. So 401k is held at fidelity, but the target date fund options are through Vanguard. Where the heck is my money actually being held? And I could see how this is a little bit confusing because

To answer the question directly, your money is actually being held at Fidelity. Fidelity is the custodian in this situation. And Vanguard is just one of the fund providers in your 401k plan. Again, think about it like a US stock mutual fund. You might have a

a Fidelity fund in there, you might have an American funds, you might have a dimensional fund, those are the fund providers. So in this case, Vanguard is the target date mutual fund provider inside of your Fidelity 401k. So your money is actually being held at Fidelity. Fidelity is the custodian in this situation. And there's a lot of different custodians out there. But that's how I directly answer that question.

All right. Lastly, I just thought I'd share some fun facts with you regarding target date funds. Again, Morningstar came up, a guy over there named Jeff Patak wrote an article just highlighting some of the statistics about target date funds. And this was back in 2016, but I'm sure it's on the same track and very similar. He said, as of the end of 2016...

There's roughly $772 billion invested in target date funds. So they're becoming wildly popular, partly because of the QDIAs that I talked about that came about after 2006. So they're becoming really, really popular. Three fund families control over 70% of the target date fund market. That'd be Vanguard, Fidelity, and T. Rowe Price.

He also noted that 70% of target date funds are actively managed and 30% are passively managed, which is about the same split of the overall mutual fund industry. So take all the mutual funds out there, 70% are active, 30% are passive, and that translates to the target date fund world as well.

He said that at the end of 2014, target date funds made up around 8% of total mutual fund assets, but they were taking in over 30% of the net new inflows. So they only made up 8%, but a lot of new money was flowing into target date funds in 2014. And I'd be willing to bet that that trend has continued and will continue.

Two more things he noted. One was the average expense ratio of target date funds. Again, this is back in 2016. I bet expense ratios have come down a little bit, but back then the average expense ratio was 0.78% or 78 basis points. So a little more expensive to my liking, but that was the average expense ratio for target date funds. So again, really pay attention to those fees.

And then he noted that alternative investments are becoming increasingly common inside of target date funds. So again, a really good reason to open up that hood, look inside, see exactly what that target date fund owns, the positions, the asset allocation, the fees, everything before you just go putting your money in there and assuming that they're all the same.

So I'll stop there. I hope that was really helpful to you guys. If you have any questions or comments about target date funds, please shoot me an email at podcast at youstaywealthy.com. Thank you all for listening. Again, show notes can be found at youstaywealthy.com forward slash 53. Thanks again. And I'll see you guys in two weeks.

Hey, it's me again. I just wanted to say thank you one more time for listening and remind you to please, please, please leave a quick review. If you're on an iPhone, leave a quick review on iTunes. If you're enjoying the show, I'm getting great feedback from listeners just like you. And I really want to keep the momentum going. So if you have a chance on your iPhone, leave a quick review on the Apple podcast app. And thank you so much in advance for all of your help and support.

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services. ♪