There is a refreshing simplicity to the golf game of a toddler. I appreciate this because my youngest son’s passion for golf is only superseded right now by that of chocolate chip cookies and his blanket. He spends long stretches every day hitting a foam golf ball around the yard and occasionally we visit the local par three course where he brings two clubs: his putter and his driver. If he is on the green, he uses his putter. Anywhere else on the course, he uses his driver. Wind direction, location of the ball, wind speed, yardage, and all other conditions are irrelevant. There is no mental debate to determine whether the 7-iron or 8-iron is most appropriate. In addition to the benefit of simplifying an otherwise complex game, there is the added bonus that carrying two clubs is far less burdensome on the shoulders.
For all the benefits, however, this simplicity has inescapable drawbacks. Experienced golfers would score far worse if limited to only two clubs instead of the imposed maximum of 14. Golf requires low shots, high shots, long shots and short shots. A more expansive set of golf clubs equips a golfer for the specific situation.
There are many such parallels in life where simplicity is juxtaposed with complexity, each offering pros and cons. In the investment world, perhaps the closest parallel is the target date mutual fund. This type of fund is a diversified collection of underlying mutual funds designed to provide investors with the simplicity and ease of a “one-stop-shop” investment. There is no need to decide the mix of US versus non-US stocks, to rebalance, or worry about how to allocate the next contribution. They are the investment-equivalent of my son’s driver.
Such target date funds are also known as lifecycle, target retirement, or age-based funds. Nearly all well-known mutual fund families including Fidelity, Vanguard, PIMCO, T. Rowe Price, and JP Morgan provide these funds. They are generally labeled with a retirement year such as “Target Retirement 2030” so that investors can self-select into the fund that best fits their anticipated retirement year.
The great advantage of target date funds is their simplicity and ease. A 25-year old beginning investor does not have to worry about an allocation comprised of several assets but can easily make one investment. The single investment provides immediate diversification with a suitable allocation.
While the one-stop-shop simplicity has great benefits that have made this category of funds popular, there are important drawbacks which may not be as transparent. This is not to say that the funds do not play a valuable role in some situations but rather to make clear the underpublicized limitations.
Target date funds are comprised of underlying mutual funds but they’re not a best-of-breed all-star team. Nearly all of the twenty largest target date fund families uses the family’s own funds to comprise at least 90% and, in most cases, 100% of the underlying investments. Fidelity’s target retirement funds use Fidelity funds to comprise the underlying allocation, Principal uses Principal funds and so on.
Such “home cooking” means that target retirement funds fundamentally ignore a best-of-breed approach and succumb to resulting limitations. For example, if a fund family does not offer a specific type of fund (REITs, inflation protected securities, etc.), the target date fund generally does not allocate to that asset class. Moreover, by choosing only in-house funds, target date funds ignore external lower-cost versions of the same investment (i.e. S&P 500 index funds that comprise the allocation).
Conflicts of Interest
Target date funds bear the pro-rata share of expenses for the funds in which they invest. T. Rowe Price’s prospectus provides an explanation:
While the fund itself charges no management fee, it will indirectly bear its pro-rata share of the expenses of the underlying T. Rowe Price funds in which it invests (acquired funds). The acquired funds are expected to bear the operating expenses of the fund.
Nearly all target date fund providers such as Fidelity and Vanguard apply the same pro-rata expense structure. The target date funds invest in other funds and the expenses of underlying funds are passed through, in proportion to the amount of the investment.
This arrangement presents a stealth conflict for the fund providers to allocate more to higher fee funds with higher profit margins. Since equity mutual funds have higher expenses and higher margins than bond funds, there is an economic incentive to aggressively over-allocate to stocks. Additionally, there is an economic incentive to over-allocate to higher margin funds such as actively managed investments rather than passive investments, a practice which is rarely in the best interest of the investors.
It helps to start with a few generally agreed-upon observations before critiquing the tax planning drawbacks of target date funds:
- Target date funds are designed for, and most often utilized by, investors who have a retirement date in the future. Retirees are not well-served by these investments.
- Investors who are still working are likely adding to their investments, not withdrawing. Most pre-retirees are regularly contributing to their investments, even if simply through 401(k) or 403(b) retirement savings.
- Most investors are well-served to invest more conservatively as time passes and retirement approaches. That is, investors typically hold a higher percentage in stocks at age 30 than at age 60. Target retirement funds apply this logic and gradually become more conservative over time.
- A diversified investment of stocks and bonds, if left alone, is likely to become more aggressive as time passes since stocks outperform bonds over long stretches.
Keeping with this last point, a balanced fund manager attempting to maintain a consistent level of risk will generally need to sell stocks and buy bonds in a process referred to as rebalancing. In the case of a target date fund manager who is reducing the level of risk over time, the need to sell stocks is magnified as both points 3 (becoming more conservative over time) and 4 (stocks outperforming bonds) are at play. As a result, target date funds are generally selling stocks over time, generating realized taxable gains which are then passed through to the investors.
There is a more tax-efficient solution for an investor who is adding to savings each year. Instead of using a single target retirement fund where new contributions are automatically invested proportionately in stocks and bonds, the far more favorable approach from a tax-perspective would be to maintain separate allocations to stocks and bonds. This investor could simply use any new contributions to purchase the underweight asset classes and rebalance the portfolio without negative tax implications. With any reasonable level of contributions to a portfolio, the investor may be able to defer taxable realization of any gains until retirement.
Another drawback is that target date funds dramatically reduce tax-saving opportunities such as tax loss harvesting or charitable gifting of appreciated securities. An investor who builds an identical allocation to a target date fund, albeit with all of the underlying asset class investments, will have far greater opportunity to exploit these opportunities presented by the tax code.
At the 40 Yard Line…Now What?
Most target date funds are designed to get investors to retirement and no further. Resultantly, the allocations become more conservative until the target retirement date and thereafter remain a static allocation. Left to the strong force of inertia, investors who remain in such funds after the target date will be stuck with a constant allocation that will likely not reflect their changing needs.
You ≠ Warren Buffett
Not every golf shot is identical. The benefit of playing with 14 clubs is that you can adapt to the often dramatically different conditions presented by each shot. Drawing a parallel to investing, not every investor is identical. Each investor has unique objectives, needs, risk-tolerance, and tax situation.
Aside from different expected retirement dates, target date funds treat investors equally. Everyone with an expected retirement around 2025 is assumed to have identical objectives and identical levels of aggressiveness or conservatism. Yet it is safe to assume that you and Warren Buffett face different tax levels, return objectives, and would react differently to significant losses. The reality is that two people expecting to retire at the same time often have important differences that necessitate customization, not generic inputs.
If I don’t mess things up and my son continues to play the game of golf, there will be a time when he uses more than two clubs. He will graduate from the current hand-me-down starter set into another hand-me-down set, albeit with a few more clubs. It will create additional complexity and add additional weight to the bag but be for the better.
This evolution can similarly be applied to investing for retirement. There is certainly a beneficial place for the simplicity of target date funds. For most investors, however, there will be a time and place when the costs of this ease add a cumbersome disadvantage.