William of Occam was a Franciscan friar, theologian, and philosopher who lived in England from 1287 to 1347. He is known to us today mostly from the problem solving principle he formulated known as Occam’s razor. Although he never said it this clearly Occam’s razor can be summarized as follows:
The best solution to a problem is the simplest solution that works. Complexity should only be added if it measurably improves the solution.
It is called a razor because it demands that you cut out all unnecessary complexity and focus only on the few simple things that solve the problem.
In designing your investment plan you should keep Occam’s razor in mind and design the simplest plan that meets your investment needs. Complexity should only be added if it measurably improves your plan.
What are Target Date Funds?
Target date or Lifecycle funds are designed to be the simplest type of investment. The idea is that you can purchase a single fund that will last your entire working life. The money you invest is automatically allocated between one or more stock funds and one or bond funds, rebalancing is done for you, and the mix of investments automatically becomes more conservative as you approach retirement. The only thing you need to do is regularly add money to the fund.
Target date funds definitely meet the simplicity requirement of Occam’s razor, but are they the best solution for your investment needs or can you measurably improve your investment plan by adding a little more complexity?
In a recent post titled (Avoid the Tyranny of Choice) I introduced the Thrift Savings Plan (TSP) which is the defined contribution retirement plan for US Federal Government employees. I stated that the beauty of the TSP was its simplicity. Only five investment options are offered; two US bond funds, two US stock funds, and a foreign developed markets stock fund. I suggested that the best way to simplify your investment plan is to try and replicate the TSP.
All of this is true, but I didn’t tell the entire story. In addition to the five investment funds the TSP also offers target date funds, which it calls Lifecycle Funds. Understanding the TSP’s Lifecycle Funds will give you a good idea of how target date funds work and whether they are the right choice for you.
Target date funds are named for a date in the future. The “target date” is the date you expect to retire. For example, the TSP has target date funds named L 2020, L 2030, L 2040, and L 2050. You would presumably choose to invest in the fund with the date closest to your expected retirement, although this isn’t required.
Structure of Target Date Funds
A target date fund is usually constructed as a “fund of funds.” This means that the target date fund is made up of investments from several other funds. This is true of the TSP’s Lifecycle Funds. They consist of allocations from the five main TSP choices in amounts deemed appropriate for the “average” investor retiring close to the date in the fund’s name.
This often creates an extra layer of expense. In most target date funds you pay both the expense ratio on each of the underlying funds as well as an extra expense for the target date fund.
Over time, as the target date draws closer, the allocations in target date funds become more conservative. For example, let’s look at the TSP’s L 2050 Fund. This fund is designed for someone just starting out their career. They probably have thirty-five or more years left to work.
In January of 2015 the L 2050 Fund has an allocation to stocks of 85%, with only 15% allocated to bonds. Each quarter the investment mix becomes slightly more conservative until in 2050 the mix will be 20% stocks and 80% bonds. The starting point, ending point, and how the fund’s allocations change in between is known as the fund’s glidepath. This is all done automatically without any action required from individual investors.
Target Date Funds as Defaults
The amount invested in target date funds has grown exponentially over the last several years and there is no end in sight. According to Morningstar the amount invested in target date funds was more than $500 billion in 2013. Asset-management consulting firm Casey, Quirk & Associates forecasts that nearly half of the projected $7.7 trillion in US defined contribution retirement plans in 2020 will be in target date funds.
This fast growth is mostly due to a law passed by the United States Congress in 2006 making target date funds an acceptable default option for retirement plans. If you sign up for a retirement plan but don’t specify how you want your money invested you will likely be automatically signed up for a target date fund.
Since many investors never change from the default option you could very well be invested in a target date fund and not even know it. This is all the more reason to learn about the advantages and disadvantages of target date funds and determine if they are the right choice for you.
Advantages of Target Date Funds
- Simplicity – There is no simpler investment plan than target date funds. If the thought of choosing investment options and allocating money between them overwhelms you, and if you have no desire to learn about investing, target date funds might be the right choice for you.
- No Need to Rebalance – This is a subset of the simplicity advantage. Most investment plans require maintenance to keep the mix between stocks and bonds close to what you decided was optimal for you. This is called rebalancing. Many people don’t do this, and, over time, their investment mix becomes more risky than they bargained for. With target date funds the rebalancing is done for you.
- Avoid Big Mistakes – With target date funds you will avoid the biggest mistakes most investors make such as taking way too little risk early in life or way too much risk later in life. The amount of risk you take might not be optimal for your situation but it will keep you out of major trouble.
Disadvantages of Target Date Funds
- Lack of Flexibility – Target date funds are designed to meet the needs of the “average” investor retiring near a certain date. However, your risk profile might not match that of the “average” investor of your age. With only a little extra work you can design a plan specific to your needs.
- Cost – For me this is the biggest disadvantage. The simplicity of target date funds doesn’t come free. Often you pay two levels of fees, one for the underlying funds and one for the target date fund. If this extra fee costs you 0.50% per year over the course of your life you will end up paying tens of thousands of dollars in added fees. When you consider that it would take you, at most, several hours a year to devise and maintain your own plan this is a steep price indeed.
For most people I don’t think target date funds are the best solution to the investment problem. While they meet the simplicity requirement they ultimately fail Occam’s razor in that investment performance can be measurably improved by adding only slightly more complexity. In my next post I will suggest an investment plan that provides simplicity and overcomes many of the disadvantages of target date funds.
- Check your 401(k) plan to see if your money is going to a target date fund. Due to target date funds being the default option in many plans you might be investing in a target date fund and not even know it.
- Look at the options in your 401(k) plan and determine what the expense ratio is on target date funds. Also, look at what the expense ratio is on index funds offered by your plan. If the difference is 0.50% or more you are paying far too much for the simplicity of the target date fund. Even if it is less than a 0.50% difference you could save a significant amount of money over time by designing your own plan.