Target Date Funds - What You Need to Know

Today we're going to talk about target date funds. Target date funds are the ultimate in set it and forget it investing because they do three really useful things for us that require no additional work or management on our part. First, they give us an appropriate asset allocation for our age. By asset allocation, I mean our mix of stocks and bonds. For example, I. I am 40 years old, so I invest in the 2050 Target Date Fund in my Vanguard 401K. The year 2050 is about the year that I will turn 65. So the fund knows I'm roughly 40 years old. And thus it gives me an asset allocation of about 90% stocks and 10% bonds. About 2/3 of the stock are US, the other third are international. So I get a very reasonable, highly diversified, lowcost mix of US and international stocks and bonds that is appropriate for my age. The second thing target date funds do is they adjust our asset allocation automatically as we age. It's one thing to have a 90% stock, 10% bond portfolio at age 40. It's an entirely different thing to roll with that aggressive of a portfolio into my 60s. And at age 40, I don't really care at all if the stock market loses half of its value tomorrow morning because I'm more than 20 years away from needing those assets. In fact, perversely and selfishly, I kind of want the stock market to do bad so that all those juicy stocks I want to buy anyway go on sale. A stock market crash for a young person is synonymous with Black Friday after Thanksgiving. It's the sale we've all been dreaming of. However, I do not want to wake up on my 65th birthday to see that half of my lifetime savings has disappeared in a housing crisis or pandemic stock market crash. In order to mitigate against this, we want to shift our asset allocation slowly and deliberately as we age. So we drop from holding 90% of highly volatile stocks to no more than 50 or 60%, with a corresponding increase of 40 to 50% of more stably priced bonds. That way, if a market crash occurs in my 60s, I might see a 10% decrease in my portfolio, not a 30 or 40% decrease. Well, you can adjust your asset allocation manually over the years if you're confident in managing your own portfolio. Or you can just choose a target date fund to do it for you. Each year I get closer to the year 2050, the fund slowly ratchets up the percentage of bonds that I own. I don't have to do anything. This concept of adjusting your asset allocation over time is Known as a glide path. We glide from a 9010 portfolio to a 6040 portfolio. As we age, a Target Date fund will follow the glide path for you. The final way a target Date Fund aids us in setting it and forgetting it is that it automatically rebalances itself throughout the year. What I mean by rebalancing is that we want to maintain our desired percentages of assets at all times. Let's say that desired percentage is 60% US stock, 30% international stock, and 10% US bonds. If you purchased three individual index funds in those relative percentages, they would stay at your desired ratio for a pretty short period of time in most cases. That is because the US Bond market and international stock market do not have a perfect correlation with one another. They rise and fall at different rates. And that's a good thing. That's the diversification we want. The problem is that if the international economy goes on a tear and the US Bond market has a terrible year, then you don't have a 30% international stock and 10% US bond ratio anymore. You have something like a 35% international stock and 5% bond ratio. That's not the asset allocation you want. That's the wrong balance for your funds. So you have to go into the account and rebalance by selling the overperforming asset and buying the underperforming one until you achieve your desired balance again. Well, a target Date fund rebalances itself regularly, every month or every quarter. You don't have to go into the account and buy and sell anything. So that's what makes target Date funds awesome. They give you a rational asset allocation. They follow a rational glide path, and they rebalance at a rational interval. Now that I've got you hopefully pumped up on the glory of the target Date Fund, let's talk about some important nuances. First, there can be a terminology trap. These funds are known also as target retirement funds because the date you're often picking is allegedly your retirement. But I actually hate the term target retirement funds and do not recommend thinking of your retirement timeline at all when choosing which target date fund to use. The reason for that is some people will retire at age 45, some at 55, some at 75. This retirement timeline should not really be our primary concern when it comes to the longevity of our nest egg. Rather, the point of quote, unquote retirement savings is is to make sure we don't run out of money before we die. When we die has nothing to do with when we retire. In financial planning, we do our math to create a nest egg to support us until age 95. I may very well retire in the year 2040, but I will always use a 2050 target date fund because the year 2050 is when I turn 65. I think these funds should be called target 65th birthday funds. That would be more clear and more aligned with their intended purpose. This brings up another question I see clients wrestle with. Let's say One spouse is 40 and the other is 30. Which target date Fund should the household use? I think the answer is to take the average age of the couple in our example, the couple should think of themselves as 35 years old and use the 2055 Target Date Fund. I think that's the simplest way to think about this. Otherwise it becomes very difficult to know and manage the overall asset allocation of the family if one spouse has X dollars in one Target Date fund and the other spouse has Y dollars in a different target date fund. Another wrinkle with target date Funds relates to risk tolerance. Occasionally I get a client that says, yeah, Tyler, tolerate, totally get it, but I want to take more or less risk than this glide path will take me on. So maybe a Target Date Fund is not for me. To that I say just pick a slightly different fund. If you are 40 years old and want to take more risk, don't pick the 2050 fund. Pick the 2055 or 2060 fund, which will keep more of your assets in stocks for a longer period of time. If you want to take less risk, pick the 2045 or 2040 fund. That'll have more bonds today and it'll shift you away from stocks faster in the years ahead. One thing to be mindful of with Target Date funds is that they are not all created equal. Some are awesome and some are awful. You really have to look under the hood to understand which funds the Target Date Fund is purchasing in order to create the underlying asset allocation and most importantly, what the fees are. The fees are often expressed in a term known as an expense ratio. I described expense ratios in a previous Finance 101, so go back and check that out for more details if you want. Basically, an expense ratio is a fee you pay to the firm that created the investment. It is expressed as a percentage of your total dollar amount in that investment. If the expense ratio is 1%, you must pay 1% of your total holdings to the investment company each year. So expense ratios are important to pay attention to. They erode your wealth and you want to keep them low. Some target Date funds, like the ones at Vanguard, have very low expense ratios the 2050 fund I use has an annual fee of 0.08%. That is awesome. If I have $100,000 in the fund, I pay 80 bucks a year for those three benefits we talked about earlier. That is a dang good deal for a fund that guarantees a good asset allocation, follows a glide path and automatically rebalances. Some target date funds have terrible expense ratios like 0.75% up to 2% at 1.5%. If you have $100,000 in the fund, you have to pay $1,500 a year for those benefits. Have a million dollars in the fund and you're paying $15,000 every year. That is not a good deal. Don't do that. Find lower cost individual funds and manage the account yourself or find a non gross financial planner to help you. I do this all the time with clients. I get them to stop using really awful target date funds and just teach them how to adjust the asset allocation themselves so they don't waste thousands of dollars in these crappy funds every year. The big brokerages like Vanguard, Fidelity and Schwab have great low cost target date funds, but you do have to watch out for Fidelity a little bit. They offer three target date funds for each target year. One of them is super cheap and awesome, one of them is a little worse and one of them is pretty bad. You have to make sure you are buying the index fund investor class shares to get the low cost version at Fidelity. Another thing I like about target date funds is the ease they bring to estate planning. I could follow my own glide path and rebalance my own accounts. I could. I'm a finance nerd. I love this stuff. My wife, she is not a finance nerd and she barely tolerates this type of conversation. She decidedly does not want to create and follow a glide path with quarterly rebalancing. So even though this is my professional field, I use target date funds in almost all of our accounts because if I die, no one needs to do anything. Nothing needs to be changed. The investments will just roll forward on a good track into the future forever. My closing thought after all that hype about targeted funds is don't use them in your taxable brokerage accounts for myriad technical reasons that transcend this 101 lesson. Just know that they are not typically a smart choice in your taxable brokerage account. Target date funds are awesome in tax protected accounts like 401s, 403s, 457 HSA and your IRAs. Also in 529s as so called target enrollment funds, with the target year being the year the child finishes high school or starts college. Just don't use them in your taxable account. They have become nearly ubiquitous in employer retirement accounts these days, which is good except for the ones that are awful, so watch out for those. They are almost always available in your HSAs and they are definitely available in your IRAs as long as you're with Vanguard, Fidelity, Schwab, etc. If you have some horrendous IRA with Wells Fargo or Edward Jones, you probably don't have access to good target date funds, but in that case you have bigger problems Anyway, Target date funds are pretty cool. You guys give them a long look. If you are into maximum simplicity and low stress, they are the ultimate in set it and forget it investing. Thanks so much for listening and have a fantastic rest of your day. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.