The Pros And Cons Of Target Date Funds

Jul 16, 2021 | Investing, Retirement

You’ve heard of them and probably have used them. They’ve gained in popularity and have been revolutionary to help investors reach their retirement goals. They’re target date funds.  While they’ve been a great financial invention, there are some specific things you should know about them before you invest in them.  On this podcast, Karl Eggerss welcomes Casey Keller to the studio to discuss.

Karl Eggerss:

Hey everybody. Welcome. Welcome to Creating Richer Lives, the podcast. If you’re brand new to the podcast, where have you been? If you’re joining us again, welcome back. We try to bring you new topics every weekend. This weekend is no exception. Today we are going to be talking about target date funds, sometimes called life cycle funds or just retirement funds, or they have all kinds of names. But they are target date funds that have a specific year on them. And the idea is, you pick the year you’re going to retire and set it and forget it. And we’re going to talk about the pros and cons of that. Some of you may have this in your 401k. Some of you may have it in an IRA or even just a taxable joint account there. You can use them anywhere, and we’re going to go through the pros and cons.

Karl Eggerss:

So in just a minute, we’re going to bring in Casey Keller, chartered financial analyst, to walk us through that. Creatingricherlives.com is our website and our telephone number (210) 526-0057, creatingricherlives.com, ton of information on there. If you go on the homepage, number one, we have a video right on the front page that really shows you what we do for clients in about a 45 second vignette, we’ll call it. And on top of that, you can go to the resources page and we have our blogs on there. We do those every Monday morning. Our chief investment officer writes those, Justin Pawl, and they’re a five minute read. They are on there. Of course, this podcast is on there. We have television interviews, radio interviews, topical blogs that we write, and they’re on all different things relating to your financial life for the most part.

Karl Eggerss:

And so, that’s what we do on the website, is try to educate, help you out. And that’s the same thing we do on this podcast each and every week. And again, we are on Apple podcasts, we’re on Spotify, we’re on Google podcast, Amazon Music, iHeartRadio, Stitcher. So we are on a ton of different platforms. And by the way, really cool, this podcast is ranked by Listen Score. And it is in the top 10% of most popular shows out of 2.6 million podcasts globally. So, pretty cool. I don’t know how they do that. I mean, I think it’s in the top 1% myself. Maybe you think it’s in the bottom 10%? I don’t know.

Karl Eggerss:

Well, if you think it’s in the bottom 10%, you probably wouldn’t be listening. Right? But it is in the top 10%. So that’s pretty cool. So I saw that this week. So thank you very much for all you listeners and the interaction and the amount of time that you listen. We try to keep them as brief as possible. Sometimes they’re longer with interviews, but we do try to keep them brief. And so, that’s why we want to get to our topic today. In studio today, it’s a brand new podcast studio, Casey Keller. Welcome back to the podcast.

Casey Keller:

Glad to be here in a new a studio here.

Karl Eggerss:

Yeah. It’s been several months, I believe, since you’ve been on. And we’ve got a new little setup here. So, of course, you guys can’t see it, which may be coming in the future video podcasts but for right now we’ll stick to audio. So one of the things we wanted to talk about today, as we mentioned at the top of the show was, target date funds. These are something that if you are an employee, you probably have this as an option. In fact, many of you may be using this as part of your overall asset allocation. And even if you’re retired and you still have your money at a 401k by a former employer, you probably still have some of your money in these. And they go by different names. If you say, I haven’t ever seen the word target date, some of them are called life cycle funds or retirement funds or whatever they’re named. They are target date fund.

Karl Eggerss:

The idea is that you pick a date of which you’re going to retire and you try to match up that risk profile with a particular basket of funds. And unfortunately, your age is only one factor. So we’re going to talk about, is this a good approach? What are the pros and cons of target date funds? So Casey, let’s get right into it. These things, I hadn’t heard about them in the 1990s, but they were invented in the 1990s by a couple of Wells Fargo investment advisors, which later became Barclay’s global investors. So these were around in the late 1990s, but they’ve really gained popularity in the last 10 years. Why don’t you first explain what they look like, what they’re meant to accomplish, and then we’ll go into the pros and cons of them.

Casey Keller:

Sure. Yeah. I think you had a pretty good description there at the onset of this. But the only thing I would probably add to that is that the funds, they’re mutual funds, first off. And they typically, if you’re looking at them, they will have a year at the end of them. So you will see a year 2020, 2035, and that is the target date feature of them. You can also see them in a 529 plans for college savings. But ultimately, just like you said, you’re trying to match your risk or your allocation for your goal of when you’re going to need those funds. And most commonly you’ll see them in 401(k)s.

Casey Keller:

I believe you see them there. That’s where you see a lot of them. They’ve become very popular there, and I’m sure we’ll get more into it, but there’s some good, some pros and cons to them. But in general, I’d say for most people, been a pretty good invention. There hasn’t been a whole lot of great new inventions in the industry in the last 20 years. But this is one of them that’s probably made a pretty big impact in a positive difference overall for the public. But again, there are some cons to them as well we have to consider.

Karl Eggerss:

I don’t think many people using them, really… A lot of people don’t know what they are, and if they did, they probably wouldn’t be doing them. So it’s good that they’re using them because it does go towards their retirement. But all it is guys is a basket of other mutual funds. It’s called a fund of funds. So when you look inside of it, it may own five or 10 different mutual funds, some stocks, and some bond funds, that’s it. And it’s just some combination. So, the way they’re structured is, the longer you go out, the more aggressive it’s going to be because you have more time on your side, which is generally accepted. We buy that as well. If you’ve got more time, you can afford to be more aggressive. And so, the way these work is, if it’s a 2045 fund, for example, then it may own 80% to 90% of the fund is in the stock market.

Karl Eggerss:

And the other 20% would be in the bond market. And as you age, or as the fund gets closer to that date, it automatically rebalances and gets more and more conservative. The main problem with that is that there’s other factors. It’s not just about your age. That’s one factor to take in consideration what your risk should be, but they’re not taking into consideration the market environment, interest rates, the economy, what your financial situation looks like, maybe what other assets you have. So, let’s first talk about the pros, and then we’ll get to a lot of the cons. I just described some of them, but we’ll get into the details. But what are the pros? You mentioned earlier, this has been a great invention. Why has this been a great invention?

Casey Keller:

I would say the primary reason for that, Karl, has been that it’s a default fund in a lot of 4019(k) plans. So when a new employee comes in there and they match the age of the employee to maybe a reasonable target retirement date, based on their age, and it puts them in an allocation that is reasonable for their age. A lot of times folks go in there and they don’t know what to do and their 401k, and they either leave it in a stable value fund that’s way too conservative, or maybe something that’s way too aggressive. It does a reasonable job of putting most people in an allocation that’s appropriate for them for a longer term. So it’s helping people simplify retirement investing. And I think that’s the main benefit of it. So that’s probably the primary. I would say that the biggest benefit is just simplifying.

Karl Eggerss:

Yeah. And you brought up a good point, that probably the number one factor of how risky you should be, should be how much time do you need before you need those funds? And so, if you have 25 or 30 years, then it makes sense that that fund is going to be very aggressive, and you should probably be in that because of the fact that it’s going to be more stocks and that makes sense as we know. But there are other factors. I think the thing that’s interesting is that target date funds came along around the same time that the 401(k) structure changed. So you mentioned the default fund. A lot of companies now, you have to opt out of their 401(k). So you become a new employee, it’s going to say, “Hey, after six months being here, we’re going to start deducting from your paycheck. And if you don’t want to do that let us know.”

Karl Eggerss:

So that’s caused a lot of people to save when maybe they wouldn’t have. The other thing that you brought up is really interesting, which is, I remember back in the 90s, for people who were risk averse, they would keep their money in the stable value fund, as you mentioned. And it’s called different things, but it’s essentially a money market. Well, back then it was paying 6% and it was fine. And so, now if they do that, they’re literally not making any money but falling behind. And so, what happens now, we’re seeing this, a lot of people don’t do that anymore, fortunately. They say, “Oh, I have a target date fund.” I don’t think they really understand the risk that they’re taking. And I’m not saying they shouldn’t take that risk. I’m just saying they don’t know that risk. Because they haven’t looked inside the fund. They just simply say, “Yes, I’m going to retire in 2045 or 2065, hence I’m going to buy that particular fund. And that’s where my dollars are going to go.”

Casey Keller:

Exactly. And really, since they’ve gained in popularity, the investments they are investing in, stocks and bonds, have been doing really well. So, outside of COVID, and even with COVID drop, when you’re adding to your 401(k) regularly, and depending on how often you look at it, some of your contributions may have overcome some of the volatility, it smooths it out for sure. And it causes less alarm potentially than other investments or if you’re looking at a bunch of different investments in there. And so, that’s one thing to consider. It’s just been a good environment for it. The stocks and bonds have done really well in the last 10 plus years.

Karl Eggerss:

Well, and you mentioned simplification, and that’s a big deal. Because how many people do you know that didn’t want to invest in the markets, come to you and say, “I’ve got 20 options on my 401(k). I have no clue how to allocate it.” This does solve that issue a lot because it owns stocks. It owns international stocks, small caps, large caps, and it owns bonds, both international and domestic. So you get diversification, but that does lead into some of the negatives to it. Is it really diversification? And the answer is, a little bit. But what are you missing when you invest in one of these funds? Generally speaking.

Casey Keller:

Generally, I’d say one of the first thing that stands out is inflation protection. Stocks and bonds, stocks, arguably, certainly have an element of inflation protection over longer periods of time. But like in the last several months, commodities have done really well. You’ve had periods like in the 80s where gold did really well. You’re not going to see gold and commodities in these types of funds. So that’s one whole. And then the other thing is, they’re using risk management bonds for risk management. Bonds have been working well for risk management for the last, and we’ve been in a period of declining rates for 40 years, so they’ve done well. But if we ever get in a period like the 70s or 80s, where we have persistent rising interest rates, they’re probably not going to hold up as well. And so, there’s not other options in there to help protect or to help mitigate portfolio risks. And bonds may not do as good of a job in the future as they’ve done in the past.

Karl Eggerss:

Before we get too much into what they don’t offer. One big negative to them is really the lack of customization. So, for example, if you own one, you’ve retired, or it’s in an IRA because these are available outside of a 401(k). They’re just very popular in 401(k)s. But if you want to take $100,000 out of your $500,000 account, you have to sell the whole fund. And so, therefore, you’re selling stocks and bonds. Well, what if that happened in March of 2020? You probably, if you were smart about it, you would have taken money specifically from your bond allocation not from your stocks, because they were down and you wanted them to come back. You don’t have that option in a target date fund, right?

Casey Keller:

That’s right. And that’s why they certainly make better vehicles for accumulators, people saving in their earning years where they in a 401(k) is great. But for those in retirement or are approaching retirement, they become less optimal for that exact reason. You cannot cherry pick, you have to sell the entire fund, which means you are fore selling the stocks as well as the bonds in there. You can’t separate the two.

Karl Eggerss:

I will give you a little pro tip though. You were one of the ones that told me to do this originally, and it comes in the form of, if you are somebody that uses a robo-advisor, it’s the same thing, you have an automated program allocating this once you’ve set it. The pro tip or the trick is, if you do that and you wanted to take money from the bond side but you couldn’t, you have to sell the whole thing, go up the risk level when you take that money out. So what you’re doing is… Or down, depending on the situation. So what you’re doing is, the very next day you take the withdrawal you change your allocation by going up the risk ladder or down. So you go to a 2055 fund or a 2035 fund from a 2045 fund, for example, and you are changing your allocation. That’s the most customization you can do.

Casey Keller:

You can do that. And it’s just more complex. To have to go in there and see which fund has the right… To do the math to go. I was at 50% equities with this fund, now I’ve taken X amount out of the fund because I’ve sold, so what would the allocation be after that sell? And how do I rebalance? You’re effectively rebalancing by buying another fund that has more equity exposure. So it certainly can work that way, it’s just more complex and requires a lot more effort to do that.

Karl Eggerss:

Yeah. And again, these have been really good for a lot of people, to your point. We’ve been in a bull market for a number of years, not only in the stock market, but the bond market. I think, and we talk about it on the show all the time, it starts with a financial plan. Because if haven’t looked under the hood, you don’t know how much international exposure you have. You don’t even know how much stock exposure of your head. So when you do a financial plan and you look under the hood of what that fund actually owns, you can coordinate it with your spouse, with your outside investments, and really see, you may be way over allocated in US stocks for example, or way under allocated. So, picking that fund, if you’re using one, shouldn’t be an isolation. You should look at the big picture.

Karl Eggerss:

But on the investment side, when you talked about what’s missing, for example, gold may not be in there or real estate, alternative funds. This is a time you and I both believe in alternative funds, which are things, and we’ll talk more about this in the weeks to come, but to be really simple, alternatives are really anything that’s not stocks or bonds. Let’s just say that to make it simple. You don’t have a lot of those options in target date funds. You’re pretty much allocated to stocks and bonds. So to your point, in an environment where stocks aren’t cheap, bonds certainly aren’t cheap, for people wanting, I want something different, you don’t have that option in a target date fund.

Casey Keller:

Which I think argues for, the more wealth you’ve accumulated in these funds, the more it argues for getting away from them. To get more diversified.

Karl Eggerss:

Yeah. And it’s challenged because sometimes you’re handcuffed. I mean, the employer is dictating what funds you have to choose from. And you and I have looked at a lot of clients, 401(k) options, and sometimes there’s no rhyme or reason to them. And may be there’s a commodities fund, and an international real estate fund, and a large cap value fund. And then target date funds, like who came up with that? [crosstalk 00:16:45].

Casey Keller:

I’d love to know what [crosstalk 00:16:46].

Karl Eggerss:

If you’re going to have a small cap, have a mid cap, have a large cap. If you’re going to have a value, have a growth. There needs to be the full compliment and there’s not. So even if an employee wants to do that, it still is a challenge. So, I think it also points to the fact that you should have some outside money outside of your 401(k) that you can dovetail if you’re using a target date fund. Like, again, maybe your outside money is real estate, is alternatives, is gold. Things of that nature that can blend nicely with a target date fund. Because again, a target date fund over the real long-term is going to do a lot of the heavy lifting, but further customization, like you said, is not just a stock or bond thing. What if you want to go to more of the value side of the stock market right now? You can’t do that with a target date fund. And frankly, you’re probably leaning too far to the growth side.

Casey Keller:

Correct. Yes. And if you’re fortunate, your 401(k) has those options. You can always compliment the target date and add those in as a satellite approach, where you have the core in the target date fund. And you add on the fringe. Some of these other allocations that you have less of an allocation to, to at least add more diversification. So, value and other things, if they’re options in your plan.

Karl Eggerss:

Yeah. And one other thing we didn’t mention is that, there are target date funds that are through date. Meaning the date goes past. So, for example, we pass 2020. That doesn’t mean the fund liquidates, it’s 100% cash. It may go down to certain allocation and stay there. So maybe the lowest it’ll ever go is 30% stocks, 70% bonds, and then it just stays there. It’s almost like a US savings bond. It goes past the maturity date. So you need to look in your particular one, if you’re using them, not only how are they constructed, what do they own, but in addition, how does it work?

Casey Keller:

It’s important. And most of the ones in 401(k)s, and there could be exceptionists, but the most ones I’ve seen are the through version, where they are going to still stay allocated in a meaningful way to stocks even after that date. Meaningful, I’m meaning, at least 30%. In fact, I looked at one before we got on the podcast, it has a 2020 date, which obviously, it has passed. And it was still had 45% in stocks.

Karl Eggerss:

Yeah. Who would think that? Because the goal of somebody retiring thinks, I’m going to be conservative, which that’s a fallacy. Just because you’re retiring doesn’t mean you should be conservative. Right? You still have a lot of years left in retirement. So that’s the problem. I would say, if somebody is using these, ignore the numbers. Completely ignore the numbers. Look at the allocation in terms of stocks and bonds, look at really what it owns, and then work backwards and figure out, does it make sense for you to own that?

Casey Keller:

Right. And in the case of retirement, probably still makes sense outside of some extreme circumstances, but on the other end of the spectrum, like 529s, you don’t want the through funds. You want them to be mostly cashed by the time your child’s going to be attending college, because you don’t want to be writing checks out of the 529 and have the market go down 30%. And all of a sudden what you thought you had saved drops significantly. You want them. And those are usually geared, those age based programs are typically where they get very conservative by the target date. So those are a little different. But yeah, like you said, it’s definitely important to know what you own and how they’re structured. Because in the flip side, you may own one that goes down to 0% stocks in the target date of your retirement. And all of a sudden, you don’t even realize you have a stable value fund now that’s earning nothing.

Karl Eggerss:

Sure. No, it’s a really good point because there is a distinction between a target date or age based fund for a specific goal like college, where you literally need that money. Whereas in retirement, you don’t know if you’re going to need that money. So, you don’t want to set it to when you retire. That’s kind of meaningless. Again, outside of a big comprehensive financial plan. But I can speak from experience. I was pulling from a 529 during the pandemic. My son started college in 2020. And I was grateful that it was conservatively allocated because I had picked an age-based fund. Now, when he was a baby, it was super aggressive and it’s worked its way down. It was a perfect example. Had I had it 70% stocks and just left it, I would have had to pull from it at a really bad time.

Karl Eggerss:

Now, again, what’s the workaround? Could I have taken money somewhere else and let the market bounce a little bit? Yes. But some people don’t have that luxury and they have to take from that account. And so, that’s a really good point about, again, they can work really well for a specific goal, but most times retirement isn’t the end it’s just another… Yes, your income is going to stop. But that doesn’t mean you should ultimately get conservative that next day. You may not change your allocation at all when you go into retirement.

Casey Keller:

Exactly. And yeah, that’s a good example though of how they can work well though. I think that example of college, how it earned well when your son, your kids were younger, and it got conservative when it needed to. But it allowed you to get, I wouldn’t say that word optimal, but it allowed you to get decent returns over time. It did its job in other words, and got conservative when needed to, and you didn’t have to do anything.

Karl Eggerss:

Right.

Casey Keller:

You just deposited, saved, and it was doing all the work. You didn’t have to go and worry about changing anything, doing a lot of that work. So, that’s where they can be great. It’s just like most things in this industry is that, the products don’t know who you are, who the clients are, they’re general. And generally the rules are good and how they’re built, and they’re designed to work well for most people, in most situations, but it’s those exceptions where people can get in trouble and you got to make sure you know what you own.

Karl Eggerss:

Yeah. Because the opposite happened in ’08. I had these in ’08, and guess what? You just keep adding to them. So what you said about 401(k), that’s the biggest, powerful thing about 401(k) is it’s kind of this forced savings, people don’t really think about it. And a lot of 401(k)s now have kind of an escalator built in where you’re upping the percentage automatically, which is your savings, more and more, which is great. You’re getting raises. So, 401(k)s have a lot of great features and the target date funds are good as that first step, but as you gain wealth, as you said, and you get more sophisticated, you really need to start broadening out or at least making sure, what else do you own outside of that?

Karl Eggerss:

One other thing with target date funds is they may be part of the reason the bull market has gone on longer than many people expected. Because you think about, how many people would have been going into a money market or stable value under normal circumstances that now say, “Oh, I’ll pick a target date fund.” And they’re literally putting money into the stock market. And so target date funds, and I don’t have any statistics to back this up, but they may be accounting for a big portion of the inflows into the stock market and bond market, for that matter. And it could be really helping this tailwind of a stock market that we have.

Casey Keller:

It very well could. I have not seen any studies that confirmed that either, but it does seem reasonable to think that that’s possible for sure.

Karl Eggerss:

[inaudible 00:23:49] study that?

Casey Keller:

Yeah. I’ll take a look, [inaudible 00:23:51] get the date on that. But regardless, I think it is a point to be made that, we have had a tailwind of an incredible market the last 10 plus years. And these funds have been right in the crosshairs of the two best asset classes you could have been in. And that’s large cap stocks and US bonds. And so, there could be some challenges. I guess, I would argue for more diversification going forward, but at the end of the day, it’s still better than the alternative of not investing or doing a stable value. I still would rather advocate for having stocks and bonds and investing and saving than not at all.

Karl Eggerss:

A little plug for Covenant. So what we do is, if somebody comes in with that, we use what we call, Covenant Wealth Central, where we do look under their hood and take a deep dive into the funds and what they specifically own, not only sector and all of that, but we can look at the stocks, all of that. But again, in conjunction with your money markets, in conjunction with your spouse’s 401(k), in conjunction with your normal brokerage account. So you can really see from the 30,000 foot view, how much you are allocated to stocks, how much you’re allocated to technology, we can get pretty granular with it. And a lot of people are sometimes surprised and didn’t realize how aggressive they really were. And until a March of 2020 comes in, it’s like, “Wow, my 401(k) really went down a lot. I didn’t realize I had that much stock.” But what you said earlier about a 2020 fund being 40% or 45% stocks, most people would be shocked to hear that.

Casey Keller:

Yeah. And you would definitely have felt it in 2020.

Karl Eggerss:

Absolutely. So, again, these are good if you’re in one or two. And by the way, if you have three or four of them, you’re over diversified, okay. One is enough. But I see that all the time. But if you’re in one, we’re not saying they’re bad. We’re saying you need to do your homework because there’s a little more to it than just plopping it in there. This is not a CD. It’s not going to guarantee returns. It’s not going to some magical being happens or something happens that retirement date. This is all about just how much stocks versus bonds. They’ve made it simple. We’re grateful that these were invented, but they’re not the solution and one size fit all. So, Casey Keller, Chartered Financial Analyst, thanks for coming in. You’re the first interview in the brand new studio, the podcast studio. So, thank you very much for taking the time today.

Casey Keller:

My pleasure. I’m honored in it. It looks good.

Karl Eggerss:

All right. Thanks guys. We will see you back here next weekend on Creating Richer Lives, the podcast, creatingricherlives.com. Take care.

Speaker 3:

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