The most common Target Date Fund mistakes and how to fix them
Most 401k plans offer ‘Target Date Funds,’ one-stop investment portfolios with a mix of US stocks, international stocks and bonds that automatically get more conservative (less stocks, more bonds) as we approach retirement.
Companies like them a lot, because target date funds generally pass the Department of Labor ERISA fiduciary rules, which require 401k fee transparency, ethical integrity, and diversified options to plan participants. A company that doesn’t follow the rules can be sued. As a result they like to provide a target date fund as a solid, diverse investment option.
Target date funds are rarely the optimal solution for any individual, but as one-stop shopping goes, they can’t be beat and are very popular. They are offered in 80% of all plans and remarkably, over 50% of all 401k accounts are 100% in a target date fund. (source)
Conventionally, one identifies the date of retirement and invests in the target date fund closest to that joyous day. If you are 52 today and plan on retiring at 70 in 2039, you would pick the closest target fund date, which is probably the 2040 fund. Voila! You are done managing your portfolio. One can just keep adding to that same fund and it will dynamically change the asset allocation to have more bonds as you get closer.
For the investor starting out or someone that doesn’t want to deal with learning how to build an investment portfolio, target date funds are amazing. I’m a big fan. (Since I do like portfolio design and management, it’s not how I invest.)
But there are a few issues and drawbacks all TDF investors should know. Here are the four most common mistakes I see in 401k target date funds. (This is not investment advice. Please read the disclaimer below.)
Use the index target date fund. If you have chosen a target date fund, you value simplicity and solid returns, the hallmark of passive investing with indexes. Some target date funds are made of funds that are actively managed and significantly more expensive. Don’t use those. Instead, make sure you are in the index target date fund not the much more expensive actively managed counterpart. Usually it will have ‘Index’ in the title and be .20% or .30% ER or less.
Don’t mix target date with other funds. According to Vanguard, a third of investors add additional funds to their chosen 401k target date fund. This is very likely a mistake. Either use a target date fund, or make your own portfolio, but not both! They are really meant to be used alone.
Get the right stock percentage. Target date funds are not all built the same. The highest stock allocation for a 2035 fund is about 82% and the lowest is 53% for the same target retirement year. That’s a huge difference. You might be taking on more risk than you can handle. Or possibly worse, you may be underinvested and loose the long-term earnings you need for retirement. Here are the average stock allocation of all target date funds, start here and compare to the one you use. It shouldn’t be far off the percentage that corresponds to your year.
Know “To” vs “Through” in retirement. You might have a ‘To’ retirement fund, not a ‘Through’ retirement fund. This isn’t relevant until you retire but it’s very important. A ‘To’ fund stops changing the allocation when you reach the target date, leaving you with a static allocation for decades of retirement. A ‘Through’ fund continues to invest in less stocks as you age. Generally a ‘Through’ fund is the better choice. (But you should really revisit your entire investment strategy when retiring.)
