The target date fund has often been talked about as a model for harnessing the advantages of index investing and retirement saving without getting bogged down in managing the details of an allocation mix and a glidepath to derisking.
They are convenient and attractive in their simplicity: just contribute to one fund and let the professionals handle the rest of the complexity.
But they’re not necessarily a panacea without cost.
True, investing in target date funds is a decent plan, and we can’t let perfect be the enemy of good enough, but it’s important to understand what you’re giving up — and what you’re paying — when you make the single-fund portfolio choice.
Our friend, the White Coat Investor, shares more.
I am often asked about lifecycle mutual funds in general and Vanguard’s Target Retirement funds in particular. Readers somehow have gotten the vibe that I hate these funds. I don’t hate them, but I also don’t use them in my retirement portfolio because they don’t work for me. This post will explain why.
What Is a Lifecycle Fund?
A lifecycle fund is a balanced mutual fund, holding both stocks and bonds. It is also a “fund of funds,” meaning its only holdings are other mutual funds. The fund is automatically rebalanced to maintain its desired asset allocation as time goes by. Lifecycle funds follow a specific “glide path,” generally becoming less aggressive as the years go by. Most of the big mutual fund companies offer some type of lifecycle fund, and they are often offered 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 worst lifecycle funds only use actively managed mutual funds that are unlikely to outperform as the years go by, and they also add on a fee in addition to the expense ratios of the underlying funds. My favorite lifecycle funds, the Target Retirement funds at Vanguard and the “L Funds” in the TSP, don’t do this. Vanguard also offers the “Life Strategy” funds, which used to contain actively managed funds but now are essentially the same as the Target Retirement funds (except that they maintain the same asset allocation each year rather than becoming less aggressive as time goes on). Lifecycle-style funds are also available in many 529s; they just have a steeper glide path as the student approaches college age.
Pros and Cons of Lifecycle Funds
Advantages of Lifecycle Funds
Lifecycle funds, particularly those from Vanguard and the TSP (and the Fidelity Freedom INDEX Funds but not the older, actively managed Fidelity Freedom Funds), can be great investments. They are low-cost, low-maintenance, and reasonably well-allocated among various asset classes. They provide instant diversification among asset classes and within asset classes. They are a great one-stop mutual fund shopping solution that you can recommend to less sophisticated investors and that can be placed in a 401(k) to alleviate fiduciary liability concerns. Another important advantage of balanced funds is that they are less volatile, so investors are less likely to engage in behavioral errors such as performance chasing and selling low. They’re great for someone with a single investing account, such as a Roth IRA. With all these advantages, why don’t I use them?
Problem #1: Not Available in All Accounts
We have a complex portfolio because we have four 401(k)s, two Roth IRAs, an HSA, a Defined Benefit Plan, and a taxable account. That doesn’t include 529s, UTMAs, and Roth IRAs for the kids. No single lifecycle fund is available in all of these accounts. What is the point of a one-stop mutual fund solution if you have to mix it with other funds? There is none. I 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 mix well with other mutual funds in an asset allocation. Even if you can get to an overall asset allocation you like, rebalancing involves much more complex calculations when you toss in some lifecycle funds.
Problem #2: The Dates Are Misleading
Albert Einstein said, “Make things as simple as possible, but not simpler.” I think lifecycle funds fall into the trap of making things simpler than they should be. The idea of choosing an asset allocation based on just one factor—the date you plan to retire—doesn’t necessarily account for your unique ability, need, and desire to take risk. For example, 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 bailing out and selling low, resulting in an investment catastrophe.
To make matters worse, every fund company has a different asset allocation for any given date. For example, 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 you’re going to use a lifecycle fund, choose it based on the asset allocation (and change funds depending on your desired asset allocation periodically). If you’ve got to understand asset allocation anyway, what’s the point of a date-based lifecycle fund? The only argument its proponents can really make is, “Well, it’s better than lots of stupid asset allocations people come up with either on purpose or on accident.” That’s true, but it doesn’t take a whole lot of sophistication to come up with your own desired asset allocation and implement it.
Problem #3: I Want a Different Glide Path
I’m a little bit of a control freak and like to be in command of my investments as much as possible. A lifecycle fund changes my asset allocation automatically. Automatic investing can be a great thing, but I prefer to have more control over my asset allocation. For example, we have had basically the same asset allocation for the last 15 years (60% stocks, 20% bonds, 20% real estate). It works for us in both bull and bear markets. We may take less risk as we get older, but to me, it makes a lot more sense to decrease equity allocation after a big run-up in stocks, rather than just doing it automatically at 1% or so per year. A gradual decrease is better than dumping stocks after they’ve had a bad year or two, but I don’t feel like we need to protect ourselves from this behavioral error by using a lifecycle fund.
Problem #4: I Want a Different Asset Allocation
Did I mention I’m a control freak? I also like to tinker. Vanguard’s Target Retirement 2025 Fund holds only three asset classes. Our portfolio used to contain 12. (A few years ago we simplified a bit, and we’re now down to nine asset classes.) Do you need 12, or even 9? Of course not. There is little benefit at all to having more than 10, but there are lots of benefits to having more than three. There are huge benefits to simplicity.
I also buy into the idea that “tilting” a portfolio toward asset classes with higher expected returns (like small and value stocks) is likely to result in higher long-term returns. Lifecycle funds don’t generally have small value tilts, and they don’t include REIT allocations, microcap allocations, alternative asset classes, etc. If you enjoy debating the merits of short-term TIPS vs. intermediate-term TIPS, you’re not going to be happy with a lifecycle fund.
Is it possible we’d be better off with a simpler total market-based portfolio? Of course, especially over the last decade. In fact, Mike Piper, a very sophisticated investor, has a Life Strategy fund as his only investment holding. But I’m willing to bet my life savings that I can do better than a lifecycle fund, and so far, I’m winning that bet.
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Problem #5: Lifecycle Providers Chase Performance
Lifecycle fund managers are just as guilty as the rest of us at chasing performance. Just before the 2008 bear market, mutual fund companies seemed to be competing to see who could get a more aggressive asset allocation and glide path into their lifecycle funds. Vanguard recently added international bonds to its target retirement funds. When you buy a lifecycle fund, you’re getting some active management in your asset allocation, and like all active management, you may or may not come out ahead because of it. These funds are hardly the stable long-term allocations they market themselves as. Fund companies are also tempted to place their new mutual funds into their lifecycle funds. This gives the new funds “instant assets under management,” making them appear more successful than they would otherwise be.
Problem #6: Taxable Time Bomb
One of the biggest problems with lifecycle funds is that they are inappropriate for taxable accounts because they become increasingly tax-inefficient as the years go by. As a general rule, if part of your portfolio is in retirement accounts and part is in a taxable account, you want to preferentially place tax-efficient asset classes (like stocks) into the taxable account and leave tax-inefficient asset classes (like bonds and REITs) in the tax-protected retirement accounts. This is called asset location, and while it doesn’t matter as much as asset allocation, it still matters. If your only holding is a balanced fund, then you’re necessarily holding at least one asset class in a suboptimal location. To make matters worse, as you get closer to retirement, a lifecycle fund gets more and more tax-inefficient as the bond allocation increases. Fixing the error becomes more expensive each year as the taxable capital gain in the fund increases. Lifecycle funds also don’t contain municipal bonds, which high earners forced to hold bonds in taxable should usually be using.
Problem #7: Lifecycle Funds Are (Usually) More Expensive
Many lifecycle funds add on an additional fee above and beyond the expense ratios of the underlying accounts. Even the providers that don’t do this, like Vanguard, may charge more in other ways. Vanguard offers cheaper “Admiral” shares of most of its funds if you have at least $3,000 in the fund. However, the funds held by the Target Retirement funds are NOT the cheaper Admiral shares; they are the more expensive Investor shares. For example, the Vanguard Target Retirement 2030 Fund has an expense ratio of 0.08%. I can build it myself using Admiral shares for cheaper. Now, a few basis points isn’t much, I’ll admit, and the TSP does NOT charge more for its lifecycle funds. But some fund providers charge dramatically more. Always remember that investing expenses come directly out of your investment return.
Lifecycle funds can be great investing options, especially for investors with small portfolios located entirely within a single retirement account. But they don’t work for my retirement portfolio, and there’s a good chance they’re not the best option for yours either.
What do you think? Do you use a lifecycle or target retirement fund? Why or why not? Comment below!