Why I Don't Like Target-Date Mutual Funds

Target-date mutual funds have grown in popularity over the past decade mainly due to their claim of making saving for retirement easier. With names like Retire 2030 or Target 2040, such funds allow you to invest in a basket of stocks and bonds just like any other mutual fund, however target-date mutual funds become allocated more conservatively as you near the target date -- namely, your retirement.

This low-maintenance option is attractive if you want nothing to do with investing. You won't need to annually evaluate and re-adjust your mix of stocks and bonds in a target-date fund because the fund manager does it for you. Generally, the closer you get to retirement, you'll want more of your money invested in the safer option of bonds, rather than in stocks, which are more volatile.

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The reason behind this allocation rule is to lessen the impact a stock market crash could have on your nest egg. Experts refer to this as "sequence-of-returns risk," a fancy way of saying "you picked the wrong year to retire." That's a major benefit of target-date funds: They don't leave you overexposed to stocks when it comes time to retire.

But there is no free lunch! In a rush to simplify their lives, investors jump into target-date funds without fully understanding their limitations. I'm not a staunch opponent of target-date funds -- they can still help those who don't want to deal with picking funds or managing their stock allocation. However this reason is precisely why I pass on them: you should pick your own funds and your own stock allocation because no one knows your retirement goals and appetite for stock market risk better than you. Before you select a glorified target-date mutual fund for your retirement or plunk more money into one you already have, consider the following hitches and consider an alternative called the bucket approach.

They can be too conservative

If you are far out from your target date, your target-date mutual fund will most likely hold more stocks than bonds. You're still working so you don't need the money now. If the market is down at a particular time, you simply leave your mutual funds alone and wait for the market to recover and return your capital.

But if you are retiring in the near-term, you don't have as much time for the stock market to recover because you need to sell funds immediately in order to have money to live on. The last thing you want is to sell stocks in a year they are down. So you'll want some bonds, which are more stable than stocks. Then if the stock market collapses, you sell the bonds first -- which will be down much less than stocks -- and leave the stocks to recover.

This scenario demonstrates the essential reason for smart asset allocation and why target-date funds get more conservative the closer to your retirement: The bonds help hold up your nest egg in a meltdown.

So far, so good, right? Wrong. Target-date funds can be far too conservative. For example, the stock allocation within some target-date funds gets as low as 50% in retirement. Will 50% in equities produce enough growth for you over time? Maybe, maybe not. People live longer now, so your money needs to last much longer, too, and if you don't get enough growth in your nest egg, then you are at real risk of running out of money later on.

The bucket approach alternative

An alternative to using target-date mutual funds is to use the bucket approach, where you leave enough money in cash to spend during this year; keep some money in bonds to use over the next few years; and have the rest, which you won't need until five or so years down the line, in stocks. As you need money, use the cash, then replenish the cash with bonds, and sell stocks to replenish the bonds.

This is far less arbitrary than a target-date fund, which doesn't take into account your real spending needs and becomes conservative automatically without factoring in all your other assets. If you follow the bucket approach, you will always have enough in cash for expenses so you won't have to sell stocks in a bad year. This will leave more money invested that will contine to experience compounding growth. The more money you have growing, the happier and more financially stable you will be during retirement.

You can't really set it and forget it

One perceived advantage of a target-date mutual fund is the idea that you can put money in and never have to look at it again. You're told, that since the fund gets more conservative as you near the target date, there's no need to change the mix of stocks and bonds yourself.

Sounds nice, but I don't encourage you to never look at your fund. What if the mix of stocks and bonds is too aggressive or too conservative for you? What if your retirement date has changed? Is the mix of stocks still appropriate? Is the manager doing an acceptable job?

There is no "set it and forget it" fund. So at least once a year, always be sure to do a sanity check on the underlying mix of stocks and bonds and make sure it is appropriate for your age and goals.

They're not diversified enough

If you look under the hood of a target-date fund, you'll most likely see only stocks and bonds. Personally, I prefer more diversification that looks like a mix of stocks, bonds, real estate, gold, and international bonds, to say the least.

Diversification is key. You should have many types of investments, because not all investments move in lockstep with the market. For example, in 2008, the S&P 500 was down 37%, but gold was up 5%. I'm not saying go all-in on exotic investments like timber and pork bellies, but small allocations -- say 1% to 5% -- in alternatives like real estate investment trusts (REITs) and gold can make sense.

Limited to one family of funds

When you invest in a target-date fund, you are essentially investing in a basket of mutual funds offered by that fund family. For instance, Vanguard target-date funds have all Vanguard mutual funds. That may be fine for some, but in my opinion, no one fund family is good enough to warrant this limitation.

There are some very good Vanguard funds, but is Vanguard the best in investing across the board? I'm not so sure. Rather than making a bet on one fund family, spread the money around. I look for the best Fidelity funds, the best Vanguard funds, and so forth. With a target-date fund, you are usually restricted to investing only in the funds offered by that company.

Who should use a target-date mutual fund?

Target-date funds are attractive due to their low maintenance fees and are good options for people who want to invest and never be bothered with their asset mix. But investors should be aware of these funds' limitations before storing their wealth in one.

These funds may be too conservative for investors who expect to live a long time and who are early on in their career. Funds without enough stocks to drive strong growth might be depleted sooner than a portfolio that was aggressively allocated to stocks. Also, target-date funds often invest in one mutual fund family only, so you may miss out on gains made by good managers at other fund families. Ideally, you'll want to buy the best manager in each family. Finally, target-date funds may be too conservative or too aggressive depending on your personal objectives, making it risky to think of them as "set it and forget it."

Investors who spend the time to learn about the bucket approach to investing or how to invest and diversify can create their own target-date fund, one that is far more diversified, has the ability to pick a fund from any mutual fund family, and can be as aggressive or conservative as need be. That's a fund that doesn't miss its target.

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