Target date funds are frequently lauded as a method to leverage the benefits of index investing and retirement saving, while avoiding the nitty-gritty of managing an allocation mix and a derisking glidepath.
Their convenience and simplicity are undeniably appealing: one only needs to contribute to a single fund and leave the rest of the intricacies to the professionals.
However, they are not without costs and shouldn’t be seen as a one-size-fits-all solution.
Indeed, investing in target date funds can be a good strategy, and while it’s not perfect, it can be good enough. Yet, it is crucial to understand the compromises and the costs when choosing this single-fund portfolio.
The White Coat Investor gives more insights into this.
Inquiries often reach him about lifecycle mutual funds in general and Vanguard’s Target Retirement funds specifically. His readers appear to have gathered the impression that he detests these funds. While he doesn’t detest them, he doesn’t use them in his retirement portfolio because they don’t fit his needs. He explains why in this post.
Understanding a Lifecycle Fund
A lifecycle fund is a balanced mutual fund, comprising both stocks and bonds. It’s a “fund of funds,” meaning its only holdings are other mutual funds. The fund is automatically rebalanced to maintain its desired asset allocation over time. Lifecycle funds follow a specific “glide path,” typically becoming less aggressive as time passes. Major mutual fund companies offer some sort of lifecycle fund, and they are frequently available within 401(k)s. In fact, 62% of 401(k) participants use lifecycle funds, and these funds account for 24% of all 401(k) dollars.
The poorest lifecycle funds solely use actively managed mutual funds that are unlikely to outperform over time, and they also impose an additional fee beyond the expense ratios of the underlying funds. His favorite lifecycle funds, Vanguard’s Target Retirement funds and the “L Funds” in the TSP, don’t do this. Vanguard also offers the “Life Strategy” funds, which used to include actively managed funds but now are virtually identical to the Target Retirement funds (except they maintain the same asset allocation each year rather than becoming less aggressive over time). Lifecycle-style funds are also available in many 529s; they just have a steeper glide path as the student nears college age.
The Good and Bad of Lifecycle Funds
Pros of Lifecycle Funds Lifecycle funds, especially those from Vanguard and the TSP (and the Fidelity Freedom INDEX Funds but not the older, actively managed Fidelity Freedom Funds), can be fantastic investments. They offer low cost, low maintenance, and a reasonably well-diversified allocation among various asset classes. They provide instant diversification among and within asset classes. They serve as a fantastic one-stop mutual fund shopping solution for less sophisticated investors and can be incorporated into a 401(k) to mitigate fiduciary liability concerns. Another significant advantage of balanced funds is that they are less volatile, so investors are less likely to engage in behavioral mistakes such as performance chasing and selling low. They’re ideal for someone with a single investment account, like a Roth IRA. So, why doesn’t he use them?
Issue #1: Unavailability in All Accounts He has a complex portfolio comprising four 401(k)s, two Roth IRAs, an HSA, a Defined Benefit Plan, and a taxable account. That doesn’t even include 529s, UTMAs, and Roth IRAs for the kids. No single lifecycle fund is accessible in all these accounts. What’s the use of a one-stop mutual fund solution if it needs to be mixed with other funds? There isn’t any. He could hold lifecycle funds in
some accounts, but balanced funds in general and lifecycle funds with their ever-changing asset allocation, in particular, don’t blend well with other mutual funds in an asset allocation. Even if one can get to an overall asset allocation that they like, rebalancing involves more complex calculations when you mix in some lifecycle funds.
Issue #2: Misleading Dates As Albert Einstein once said, “Make things as simple as possible, but not simpler.” He believes that lifecycle funds over-simplify. The idea of choosing an asset allocation based on just one factor—the date you plan to retire—doesn’t necessarily consider one’s unique capacity, need, and desire to take on risk. For instance, the Vanguard Target Retirement 2045 fund has an asset allocation of 86% equity. In a big bear market, that fund could lose about 45% of its value. Not everyone who plans to retire in 2045 can psychologically handle a 45% drop in their retirement account value without panicking and selling low, leading to an investment disaster.
Moreover, every fund company has a different asset allocation for any given date. For instance, Fidelity’s Freedom 2030 fund is 63% equity, Vanguard’s Target Retirement 2030 fund is 64% equity, and the TSP L 2030 Fund is 60% equity. If one chooses to use a lifecycle fund, it should be based on the asset allocation (and they should switch funds depending on their desired asset allocation periodically). If one still needs to understand asset allocation, then what’s the point of a date-based lifecycle fund? The only argument its proponents can truly make is, “Well, it’s better than lots of stupid asset allocations people come up with either on purpose or by accident.” That’s true, but it doesn’t require a lot of sophistication to create your own desired asset allocation and implement it.
Issue #3: Preference for a Different Glide Path He’s a bit of a control enthusiast and likes to be in command of his investments as much as possible. A lifecycle fund automatically adjusts his asset allocation. Automatic investing can be advantageous, but he prefers more control over his asset allocation. For example, he has maintained the same asset allocation for the last 15 years (60% stocks, 20% bonds, 20% real estate). This works for him in both bull and bear markets. While he might take less risk as he ages, he finds it more logical to decrease equity allocation after a significant surge in stocks, rather than just doing it automatically at about 1% per year. A gradual decrease is better than dumping stocks after they’ve had a bad year or two, but he doesn’t feel the need to protect himself from this behavioral error by using a lifecycle fund.
He often finds himself wanting to tread a different path than the one the majority takes.
Issue #4: Desire for a Different Asset Allocation As he said before, he likes being in control. He also enjoys tinkering. Vanguard’s Target Retirement 2025 Fund holds only three asset classes. His portfolio used to contain 12 (though it’s simplified a bit now and is down to nine asset classes). Do you need 12, or even 9? Of course not. There’s little benefit to having more than 10, but there are many benefits to having more than three. Simplicity offers enormous advantages.
He also subscribes to the idea that “tilting” a portfolio toward asset classes with higher expected returns (like small and value stocks) is likely to yield higher long-term returns. Lifecycle funds generally don’t have small value tilts, and they don’t include REIT allocations, microcap allocations, alternative asset classes, etc. If one enjoys debating the merits of short-term TIPS vs long-term TIPS or emerging markets bonds versus developed markets bonds, then lifecycle funds are not for them. A three-fund portfolio will give the same simplicity with more flexibility.
Issue #5: Lack of Tax Efficiency While lifecycle funds can be tax-efficient, this depends heavily on the investor’s situation. One of the major tax-efficient investing principles is asset location. This refers to placing higher-tax assets into tax-protected accounts and lower-tax assets into taxable accounts. With a lifecycle fund, this is not possible since it contains both stocks and bonds. In his situation, it’s crucial to separate the two for maximum tax efficiency. If one has both taxable and tax-protected accounts, they will probably be better off holding individual funds rather than a lifecycle fund.
Issue #6: Some Underlying Funds Are Suboptimal While Vanguard’s Target Retirement funds are excellent, he still has a few gripes. The main one is that the international bonds fund is not currency-hedged, which he believes is a mistake. Additionally, Vanguard has a corporate bond bias, whereas he prefers Treasury bonds for their superior safety.
Issue #7: You Still Need a Written Investment Plan Investing in a lifecycle fund doesn’t replace the need for a written investment plan. He believes this is so important that he has dedicated an entire blog post to it. It will be more effective to use a lifecycle fund as a part of your plan rather than as a standalone investment strategy.
In summary, while lifecycle funds might seem like a silver bullet, the truth is more nuanced. Their simplicity, broad diversification, and automatic rebalancing are very appealing. Yet, these funds aren’t for everyone. They might be perfect for some, but if you need more control over your investments, want a different asset allocation, have a complex portfolio, and wish to maximize tax efficiency, then lifecycle funds might not be the best fit.