Is target date fund right for you?

Do you know what is the most common 401(k) default investment? 

It is a target date fund. 


In this post, we will talk about what they are, their pros and cons, how to pick the right one for you, and some final thoughts.


Summary

  • What is a target date fund?

  • Pros and cons

  • Pick the right one

  • Final thoughts


What is a target date fund?

Target date fund is a combination of US stocks index fund, non-US stocks index fund, US bond fund and non-US bond fund. It is basically a fund of funds. 


The name “target date”, means the fund itself is targeting a specific year of retirement. For example, if you plan on retiring in 2030, you can buy the 2030 target date fund.


As the time goes nearer and nearer to the target date, the fund will gradually increase its percentage of bond funds and decrease its percentage of stock funds, in order to increase safety. The idea is that most people will be comfortable investing a lot of money into risky stocks when they are young and working, but as retirement approaches they will want to shift their savings into dependable bonds.  If your goal is to grow your wealth while young and financial security during retirement, this kind of approach can make a lot of sense.

Pros and cons

Pros

  • Easy to use

    • Instead of mixing a few funds yourself, target date funds give you a diversified portfolio in one security. 

  • Automatically rebalancing

    • The fund will be more aggressive when your retirement date is still far away, enabling more aggressive growth.

    • The fund will automatically rebalance as you approach your retirement to make your retirement portfolio less risky.

  • Low cost

    • Target date funds have a low cost compared to other managed accounts with similar funds.

  • Low minimum investment

    • While some target date funds require $1,000 to invest in, there are others that do not have a minimum investment requirement.

Cons

  • Less control

    • You can’t sell individual holdings within the target date fund. 

    • For example, if you want to sell some bonds, you have to sell the whole target date fund.  This can be very problematic for tax loss harvesting, if e.g. some component of the fund declines in value and you want to harvest the loss by selling it and replacing it with something else.

  • No customization

    • Target date fund uses only one thing to determine your asset allocation: your target retirement year. 

    • This one size fits all solution leaves you no room for customization based on your financial situation.  

Pick the right one

There are two main things you should consider when picking the target date fund:

  1. You target retirement year

Ideally, you should pick the target date fund with a year that is most close to your target retirement year.


  1. Active VS Passive

Despite its low fee, not all target date funds are created equal, even when they have the same target date and are from the same company! 


Let’s look at an example here:

  • FDEWX: Fidelity Freedom Index 2055 Fund, expense ratio: 0.12%

  • FDEEX: Fidelity Freedom 2055 Fund, expense ratio: 0.75%


They are both Fidelity 2055 target date funds. Why does FDEEX have an expense ratio 6.25 times of FDEWX? (note: expense ratio is the cost for owning a fund.)


This is because FDEWX is passively managed, while FDEEX is actively managed. Does FDEEX (actively managed) have better performance than FDEWX (passively managed)?


Nope! 

Here is their performance comparison. As you can see, FDEWX (passively managed) has consistently out-performed FDEEX (actively managed):



Here is the takeaway: 

Always pick the target date fund that is passively managed, which has lower fee and likely better performance.


Final thoughts

If you don’t want to spend too much time picking stocks or rebalancing your portfolio, then choosing a target date fund is a great way to go. Investing with a target date fund is better than investing in nothing.


However, if you want to buy and sell specific funds, whether for tax loss harvesting or customizing for your personal financial situation, and you don’t mind spending some time rebalancing your portfolio when needed, then you can go ahead and buy individual funds instead.



You might also like:

Should I use Robo advisors?

Comments

Post a Comment

Popular posts from this blog

Two day itinerary in Portland OR

Image
This is the two day itinerary I used when traveling to Portland for a weekend trip. It includes food recommendations, waterfalls, and city attractions. Summary Day 1 Vista House Waterfalls Bridal Veil Falls Wahkeena Falls Fairy falls (optional) Multnomah Falls Horsetail falls More hiking (optional) Rowena Crest Voodoo doughnut Powell's City of Books Day 2 Pittock Mansion Japanese garden International Rose Garden Day 1 Breakfast We had breakfast at Elmer's . They have multiple locations in Portland, and they serve delicious American breakfast. Vista House On the way to see the waterfalls, you can stop by Vista house . The house itself has been closed since the pandemic. However, you will get a really good view of the Columbia River from there. There are a lot of free parking spots near the vista house as well. On the way to the vista house, we also caught a glimpse of the snowy mountain from the highway, which I think is probably Mount Hood: Here is the view from vista house: Wa
Read more

Milk Maiden and the Burp Boy

Once upon a time, there was a baby named Emma who had a secret identity. By day, she was just a normal baby, but by night, she was the superhero Milk Maiden! Milk Maiden had the incredible ability to drink as much milk as she wanted, and she used her powers to help other babies who were hungry. One day, Milk Maiden was called to the scene of a crime. A group of babies had been kidnapped by The Baby Kisser, a villain who had the evil plan to kiss all the babies on the cheek. Milk Maiden knew that she had to stop The Baby Kisser, so she set out to rescue the babies. Milk Maiden tracked The Baby Kisser to his hideout, which was a large, dark cave. She snuck inside and found the babies, who were all tied up. Milk Maiden quickly untied the babies and freed them from The Baby Kisser. The Baby Kisser was furious that Milk Maiden had foiled his plan, so he attacked her. Milk Maiden fought back, and she used her powers to drink all of The Baby Kisser's milk. The Baby Kisser was so weak from
Read more

The mean and nasty Burp Boy

  Once upon a time, there was a baby named Emma who had a secret identity. She was a superhero called Milk Maiden. Her superpower was an incredible ability to drink as much milk as she wanted. She could drink a whole gallon of milk in one sitting! Her sidekick was named The Baby Kisser. The Baby Kisser's superpower was the ability to kiss babies on the cheek. He could make any baby smile, even the grumpiest ones. Emma and The Baby Kisser were always on the lookout for trouble. One day, they heard about a new villain in town called Burp Boy. Burp Boy was a mean and nasty villain who loved to burp. He would burp so loud that it would make people's ears ring. He also loved to burp on babies. Emma and The Baby Kisser knew that they had to stop Burp Boy. They tracked him down to his hideout, which was a big, old abandoned factory. When they got there, they saw Burp Boy standing in the middle of the room, burping as loud as he could. "Stop that!" Emma shouted. "You'
Read more