4 Reasons Target Date Retirement Funds Miss the Mark for Asset Management
Topics: Target Retirement, Fees, Asset Allocation, Investment Horizon, Fidelity, Vanguard
Something to dream about as I look out my office window over the motionless, frozen landscape:
This week I wanted to look at Target Retirement funds – so I checked out two behemoth financial institutions, Fidelity and Vanguard, both leaders in Financial Services. I also wanted to apply a real-life example of 40-ish individual with his eye on retirement! The topic of Target Retirement funds has been on my mind, as many, many people I speak with about investments use this vehicle. In fact, it’s literally a trillion-dollar business ($1.8 trillion actually). I must say it’s not the worst option but there are some considerations before you plow your hard-earned money into these types of investments. I outline four thoughts below on why you might want to reconsider using a Target Date Retirement Fund.
Four Reasons Target Date Retirement Funds Fall Short:
- Investment Mix*
- Too Many/Too Few Options
- Timeline to Retirement
*More on this topic as I believe Investment Mix leads to poor performance relative to expectations.
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On a personal note
Before studying these funds, I did use Target Retirement funds and I actually apply Target Date funds today for my 529 accounts I opened to help fund my children’s college education. The reasons I would avoid them for retirement largely don’t apply for the 529 accounts. First of all, I have a choice – and I use some of Fidelity’s low-cost index funds (not higher-priced active funds with the same date – more on that later) that line up with each of my children’s expected college entrance dates. Secondly, there is room for error – you can’t get scholarships or borrow for retirement, but you have these other options for college. So if I miss on returns or contributions, I still have some options to achieve the goal of getting kids through college. It’s more about my regular, consistent saving every month, as well as a long-term tax strategy and making the best use of my time. In my opinion, the 529 continues to be the best savings vehicle for college, but you must be mindful of the tax savings potential and investment options you have (or don’t have) depending on the state where you reside. I would encourage you to read my post about saving for college if that’s something you have been thinking about. I will continue to monitor the performance of these funds in which I invest of course. Though with my children now in the 5-10 year timeframe away from starting college, I do expect a more conservative asset allocation will have a hard time keeping pace with the S&P 500 (which is not my expectation for college savings - but is for Retirement).
4 reasons Target Retirement funds may not work for you
Fees for Wall Street services and products have been trending lower - $0 commissions, lower Advisory fees, lower mutual fund fees. So that’s good for the average investor, which used to pay more than 1% for a Target Retirement fund product just 10 years ago. Some more recent articles I read and online research suggest the average is now closer to 0.50%, and some of the larger companies are better than that – by far. If you have a choice, Fidelity and Vanguard are among the best. Or maybe your 401K is run by one of these two large financial services companies. I am amazed some of the Target Retirement funds might require an upfront "load" fee of up to 5.75% - and worse that someone might use such a fund.
I’ll spend more time on these two firms, but a quick peek at two funds that an average 42-year-old might consider, if he wanted to retire in 20 years (at 62 when social security would kick in) – the 2040 Target Retirement date funds. For this particular Vanguard fund (VFORX), the annual fee is 0.14% and for Fidelity, the investor class fund (FBIFX) boasts a 0.12% expense ratio (but more on this later).
These are both very low-cost investments, so if these are your options, paying an advisor like me may not make as much sense to you. However, I would still advocate that these funds are not individualized or goal-specific, but your financial plan should be. So even if Asset Management isn’t a consideration, I can certainly help you with your Financial Planning.
Not all Target Retirement funds are created equal in terms of investment mix either. Funds are more aggressive when you’re young and become more conservative over time. But the initial allocation, the “glide-path” (how the allocation changes in your working years and early retirement) and your mix post-retirement all vary by fund. Which one is right? Which one helps you achieve your goals?
Let’s take another look at Vanguard and Fidelity. VFORX is currently about 83% stocks and 17% bonds/short-term investments. That is too conservative for me personally, particularly based on how I feel about interest rates (read my last blog post). So, depending on level of savings, appetite for risk and investment horizon, it is likely too conservative for my similarly aged peers. Read this as “You won’t have enough money to retire in 20 years!” FBIFX is 91% stocks and 9% bonds/short-term investment, which is getting closer to an allocation I could consider.
One more thought on the investment mix is “diversifying” your assets by adding a Target Retirement fund to other investments like a small-cap fund or bond fund or the S&P 500 index. However, this could easily push your allocation to become either too conservative or too risky, which is why I prefer to look at an entire household of assets to determine a proper allocation. Yes – 401Ks and IRAs are individualized but the point of what I’m doing is to manage them all together. In our household, the goal is to cross the finish line at the same time!
*Some new information here compared to the initial post is how the asset allocation of these funds leads to astonishingly lackluster performance. Let's assume Retirement is further out and some Fidelity or Vanguard 2050 Retirement funds are your options, even a more aggressive allocation has led to massive underperformance compared to the S&P 500. A quick glimpse at a 5-year comparative chart shows the S&P is up about 45% while Vanguard is slightly positive and Fidelity has a negative return over the last 5 years - what!?! Surely then in 2022, a terrible year for the S&P 500 (down about 20%) might show better results? Nope - these two funds again underperformed - by about 500-700 basis points. Pretty shocking when so many people are invested in these types of funds.
Options – too many or too few?
Let’s focus on the Fidelity example here. I mentioned FBIFX is the investor class fund, but Fidelity actually has another 2040 fund, FFFFX. Hilariously, FFFFX has an annual expense ratio of 0.75%! Even more, is that while FBIFX has a 10-year annualized return of 6.58%, FFFFX returned 6.33% (as of 3/31/20), meaning you have a worse return for higher expenses! If you’ve read my posts, you know this is kind of an issue – over the long-term, passive investing has outpaced active investing. And even more so as you consider the fees! I’ll reiterate: You have to know what you pay in fees for your investments, because no one else is going to tell you! Plus, beware of the class of shares you can choose from or that are available in your 401K.
This provides a nice segue to my point of too few investment options in your 401K. You may only have one family of funds available to you. Again, if Fidelity or Vanguard is your custodian, consider yourself lucky, because I’ve seen plenty of 401Ks with much more costly options, clearly not provided by anyone with a fiduciary duty. If you have less-popular custodians, you should certainly be wary of the fees you pay for your investments!
When will you retire? At age 60? Or age 70? How can you know? How do you know which fund to choose? The one closest to the year when you will turn 65? Sorry, but it’s more complicated than that. Picking both the 2040 fund and the 2050 fund kind of defeats the purpose of the funds as well.
So maybe you dump money into your 401K until age 65 then hope for the best. A sincere “congrats” to those that can “max out” their 401Ks – for 2023 a contribution of $22,500 – but depending on when you started and how much you earn, that may not support the lifestyle you expect in retirement. After all, $1 Million Is Not Enough. Fidelity notes you should be putting away 15% of your income toward retirement. And a Financial Plan can help you keep emotions out of investing, plus provide scenarios for retirement, adjusting for all variables including, asset allocation, savings rate, and retirement age.
So in closing, I concede that Target Retirement funds certainly aren’t your worst option – I mentioned I use Target Date funds for 529s. But in doing so, I know I have a backup plan. Do you have a backup plan if your Target Retirement funds fall short? After all, these funds aren’t specific to you. They don’t know your goals and dreams. Are you willing to save more money, work more years, or sacrifice other goals? Maybe, but that doesn’t work for my plan. There just might be better options for you as well – let’s discuss it.
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Best wishes on your financial path!
This post was created by Matt Beeby, the Founder of MHB Advisory Services. Matt has been working in Financial Services and investing in real estate since 2005, though his investment experience spans nearly two decades. He is a Christ follower, active in both his church and his neighborhood association. Matt enjoys sports and family time. Read more about Matt on his website bio.
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