Target date funds are the default investment in most 401(k) plans. Pick your retirement year, put everything in, and let the fund do the rest. The pitch is simplicity. The reality is that target date funds are designed to be a reasonable solution for the median participant in a large plan, and you may not be the median participant.
What target date funds don’t tell you
What the fund knows about you: Your retirement year. That’s it. The fund doesn’t know your current portfolio outside this account, your other income sources, your tax situation, your risk tolerance, your health, your spouse’s financial picture, or whether you’re planning to retire early or work until 70. It takes one input, a year, and builds an allocation around it.
What it’s optimizing for: The median outcome for participants who match the fund’s design assumptions. Those assumptions include average market returns, average inflation, a 30-year retirement, and average diversification across other assets. If your situation differs materially from average, the fund’s allocation may not serve you well.
The glide path problem: Target date funds shift progressively from equities to bonds as the target date approaches. This is sensible for a median investor. But per the SEC, the asset allocations among target date funds with the same target year vary enormously across fund families, the equity allocation at retirement can differ by 20 to 30 percentage points between providers. Two people in different employers’ plans, both targeting 2035, may hold dramatically different allocations without knowing it.
What target date funds cost in ways that aren’t obvious
The expense ratio is visible. The opportunity cost of suboptimal allocation isn’t.
A person in their early 50s with significant wealth outside their 401(k), a taxable brokerage account, a spouse’s 401(k), a pension, real estate equity, doesn’t need the 401(k) to be a standalone balanced portfolio. The 401(k) is one account in a broader picture. A target date fund treats it as if it were the entire picture.
Per FINRA investor education research, asset location, the strategic placement of different asset types across taxable and tax-advantaged accounts, can meaningfully affect after-tax returns over long periods. Bonds belong in tax-advantaged accounts. Growth equity belongs in taxable accounts. A target date fund in a 401(k) that holds 40% bonds is putting the right asset in the right place, but it’s also holding 60% equities in a space that might be better served by a pure equity index if bonds are better handled elsewhere.
When a target date fund is actually the right answer
Target date funds are genuinely appropriate in specific circumstances. If the 401(k) is your only retirement account, the fund provides diversification and automatic rebalancing in a single vehicle. If you’re not engaged with your investments and won’t manage a self-directed allocation, a target date fund beats a neglected one. If you’re early in your career with a straightforward picture, the simplicity is a feature.
The Bureau of Labor Statistics data shows median household savings rates remain low across income levels, which means most 401(k) participants are accumulating primarily through their 401(k) contribution, making the target date fund the appropriate primary vehicle. This criticism isn’t directed at the median 401(k) participant. It’s directed at the high earner with a complex balance sheet who is using a one-size solution for a situation that isn’t one-size.
What to look at instead
Start with the full picture. List every account, its balance, its allocation, and whether it’s taxable or tax-advantaged. Then ask: is the overall allocation, across all accounts, appropriate for my timeline and risk tolerance? Is each account type holding the right assets for its tax treatment?
If the answer is yes, the target date fund may be fine as one component. If the 401(k) allocation is distorting the overall picture, making the overall portfolio more conservative or less tax-efficient than it should be, replacing the target date fund with a single broad equity index fund inside the 401(k) while holding bonds elsewhere is a straightforward fix.
The target date fund is a good product for a problem you may not have. Worth checking which problem you actually have.
Schedule a no-obligation call with Jeff to review your overall allocation across all accounts and whether your target date fund is working with or against your actual financial picture.
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The information provided is for educational purposes only and should not be construed as investment advice. Investment strategies should be tailored to individual circumstances, risk tolerance, and goals. Past performance doesn’t guarantee future results. Consult with qualified financial professionals regarding your specific situation.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor and separate entity from LPL Financial.
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