The Smart Way to Use Target Date Retirement Funds

All the best research we have on investing says that a diversified portfolio of low-cost index funds is likely to outperform 80-90% of other investment strategies.

Simply put, index investing gives you the best possible chance of reaching your long-term goals.

And in theory, target date retirement funds – or really any all-in-one fund – can make it as easy as possible to put that research into action.

Target date retirement funds do the heavy lifting for you, combining multiple mutual funds covering both US and international stock and bond markets, giving you the luxury of contributing to a single mutual fund that requires almost no ongoing management and, if constructed correctly, should deliver superior results.

Really, it’s no different than what automated investment platforms like Betterment have introduced in recent years. In both cases, they’re simply giving investors access to high-quality, all-in-one portfolios that make the entire investment process a whole lot easier.

But not all target date retirement funds are good, and even the good ones can lead you astray if you’re not careful.

So before you put all your money into a target date retirement fund, it’s important to understand what the potential weaknesses are and how to use them in a way that actually increases your odds of investment success.

Let’s get into it!

Where target date retirement funds fail

I’m a huge fan of target date retirement funds when they’re done right. The good ones are high-quality, low-cost, and make it easy to put a solid investment plan in place.

But they’re not a cure-all and using them isn’t always the right move. Here are four things to watch out for when evaluating any target date retirement fund.

1. Cost

Cost is almost always the first thing I look at when evaluating any investment simply because it’s the single best predictor of future returns. The lower the cost, the more likely an investment is to outperform.

And like anything else, target date retirement funds come in both high-cost and low-cost flavors. I’ve seen funds that charge as little as 0.07% per year and others that charge well over 1% per year.

The more a target date retirement fund costs, the less likely it is to benefit you.

2. Asset allocation

Target date retirement funds all have a year in their name that’s supposed to correspond to the year in which you plan to retire. For example, Vanguard’s Target Retirement 2050 Fund is designed for people who plan to retire sometime around 2050.

As part of that design, the creators of the fund decide on two things:

1. The fund’s current asset allocation. That is, the mix of investments that determines both the fund’s expected return and its level of risk.
2. They way in which that asset allocation will change over time. Target date retirement funds are designed to automatically get more conservative as the investor gets older, and each fund has a different schedule for when and how this happens.

The problem is that not everyone who plans to retire in 2050 should have the same asset allocation. Depending on your personal situation, goals, and values, you might want to invest in a way that’s either more aggressive or more conservative than the default. And that’s true both right now and over time as the fund’s asset allocation changes.

In other words, the target date retirement fund that corresponds to your expected retirement year may not have the right asset allocation for your personal investment profile.

3. No guarantees

When the stock market crashed in 2008, a lot of people were surprised that their investments in target date retirement funds lost so much value. They had assumed that those investments were stable.

Target date retirement funds are made up of mutual funds that invest in the stock and bond markets, and are therefore just as subject to the whims of the market as any other investment. You can to some extent control that risk by choosing a more conservative fund, but there’s always risk.

Target date retirement funds are not inherently stable or safe investments. That’s not a knock on them, since there are never any guarantees when it comes to investing. It’s just important to understand that these funds are no different.

4. Sophistication

I want to be careful here, because for 90% or more of the population investing in tax-advantaged accounts like 401(k)s and IRAs, target date retirement funds are more than sophisticated enough. They may be simple, but the good ones use all the best research we have to construct portfolios that give you the maximum possible chance for success.

With that said, there are two places where they can potentially fall short:

1. If you’re investing within a taxable account, there are certain strategies you can use to minimize your tax cost. Target date retirement funds don’t really allow for you to use these strategies.
2. If you have a specific investment strategy you’d like to implement, you’re unlikely to find it in a target date retirement fund. I honestly don’t think this should be a concern for almost anyone, but some people may not like that they can’t tailor their portfolio just so.

How to use target date retirement funds the smart way

Clearly, not all target date retirement funds are good, none of them guarantee any kind of return, and you have to be careful even with the good ones about getting an inappropriate asset allocation.

Still, target date retirement funds CAN be a really powerful and effective option if they’re used correctly. If you find the right one that matches up with your personal investment goals and makes use of low-cost index funds, it’s a simple way to get an all-in-one investment strategy that uses the best research we have to date to maximize your odds of success.

Here’s how to use them the smart way.

1. Set your investment goals

Any good investment plan starts with a good set of investment goals. And by that I mean the personal, lifestyle goals that you’re trying to achieve, not some return that you’d like to get.

After all, the real goal of any financial decision is to create a life you enjoy. And with investing in particular, taking the focus away from returns and putting it on your personal goals will help you avoid some of the big behavioral mistakes that most investors make.

I would encourage you to explore the idea of financial independence and do your best to define what, exactly, that means to you. With that in mind, you can then start to figure out how much you should be saving and which investment accounts will help you get there.

Those decisions are the meat of your investment plan and will set you up for success no matter which investments you choose.

2. Decide on your asset allocation

Along with cost, asset allocation should be your biggest consideration when evaluating target date retirement funds. You’ll want to find one that matches your personal target asset allocation rather than simply choosing a fund based on the year in its name.

Of course, you need to know what you want your asset allocation to be before you can find a fund that matches it. This article explains how to do that: Asset Allocation: What It Is, Why It Matters, and How to Get It Right.

3. Evaluate the cost of your target date retirement fund options

Now it’s time to look at the target date retirement funds available to you to see if any of them are a good fit for your personal needs.

The first question to ask is how much they cost. The lower the better, as that improves your chances of getting positive returns.

In most cases, the biggest cost will be the fund’s expense ratio. An ideal expense ratio would be under 0.20%, though anything under 0.50% or so is reasonable. Above that and you’re looking at a significant chunk of your money going towards fees each and every year you own the fund.

You should also look for things like sales loads, trading fees, and other costs that take money out of your account and make it harder to reach your goals.

The reality is that within a 401(k), there’s not much you can do about the fees. If your lineup of target date retirement funds is high-cost, you can certainly ask your HR department for better options, but other than that you’ll likely have to choose to invest in something else.

But when it comes to IRAs and other investment accounts, you have full control over which company you open the account with and therefore which target date retirement funds are available to you. I personally have all my investments with Vanguard and really like their target date funds, but there are plenty of other good companies as well.

4. Find one with the right asset allocation

Assuming you have access to low-cost target date retirement funds, the next step is finding one that at least closely matches your desired asset allocation.

This isn’t always easy, because again the year in the name of the fund isn’t a good indicator. You really have to look at which individual mutual funds are held in the target date fund and what percentage of the money is invested in each.

Here’s a quick rule-of-thumb way to figure out a target date retirement fund’s asset allocation:

1. Go to the website morningstar.com.
2. Enter the fund’s ticker symbol into the Quote field at the top of the page.
3. Click on the Portfolio tab.
4. In the Asset Allocation section, add the value in the % Net column for Cash to the value in the % Net column for Bond to figure out the fund’s total “bond” allocation.
5. If that matches or comes close to the bond percentage of your personal asset allocation, you can feel comfortable using that target date retirement fund.

5. Re-evaluate over the years

There are three big things that can change over the years that make this decision something you should regularly re-evaluate:

1. Your options. You may gain access to better target date retirement funds or lose access to certain funds over the years.
2. Your target asset allocation. As your goals and situation changes, this will change as well.
3. Your target date retirement fund’s asset allocation. This will shift over time as well, and a fund that once fit your target asset allocation may no longer be a good fit.

Take advantage if you can, but don’t force it

If you can find a low-cost target date retirement fund that matches or comes close to your target asset allocation, it can be an incredibly helpful tool. It won’t guarantee anything, but it’s an easy way to get an all-in-one investment strategy that maximizes your odds of success.

Remember, the best research to date says that a diversified portfolio of low-cost index funds will beat 80-90% of everything else. All a good target date retirement fund is doing is putting that portfolio together for you.

But not all of them do that. If the only target date retirement funds available to you are high-cost, or if they don’t match your target asset allocation, you should look elsewhere. There are plenty of other ways to invest in a smart and simple way.

For more on exactly how to do that, you can check out my guide: Investing Made Simple.