The Problem with Target Date Funds
Target Date Funds (TDFs) are very popular in workplace 401k plans. They are often the default option, and many employees never even change their 401k investment, even if there is a better fit available.
So, what’s wrong with them?
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Double the Fees – Target Date Funds are made up of other funds, which double the fees they charge you. For example, the expense ratio for FFFHX is 0.75%, and the average fee for a 2050 Target Date Fund is 0.58%. By comparison, most index funds are ~0.10% or less.
Poor Portfolio Management – Some TDF’s are managed by an investment algorithm that may not make the best decisions. Others are actively managed and subject to the behavioral biases of the portfolio manager.
One Size Doesn’t Fit All – TDF’s do not consider your specific retirement goals, time horizon, risk tolerance, or your other investments. Since the investments are made without considering any of your personal financial details, it is unlikely to be the best fit for you.
Investment Strategy – TDF’s use a “Glidepath” that automatically rotate the investments from a riskier to a less risky portfolio over time. The glidepath is pre-determined, and may not match your time horizon or risk level. Often, younger investors in a TDF will have a much larger allocation to fixed income than is optimal. This will hamper their long-term growth.
Lack of Transparency – It is difficult to know what the risks are inside the fund. Most TDF’s are made up of 20-30 different mutual funds from the same manager. This is done on purpose by the TDF managers, so you can’t easily determine what you are overpaying for.
Poor Investment Performance – The data shows that TDF’s underperform similar investments. One research paper stated that the underperformance over 50 years is ~22%. Check out the chart below which compares a popular TDF (Fidelity Freedom 2050 Fund, FFFHX) against two other common portfolios. Even a 60% stocks and 40% bonds portfolio would have outperformed by ~100bps over FFFHX, resulting in $540k more in retirement.
Why do Target Date Funds exist? TDF’s have become a large driver of revenue for the Wall St. firms that extract large fees from them. They are incredibly profitable. There were 45 TDF’s in 2002, which then exploded to 2,778 by 2019.
A simple index portfolio of 60% stocks and 40% bonds outperformed the Fidelity Freedom 2050 TDF by 98bps.
