The other day I was discussing retirement investing with an old high school buddy, and he asked me about Target Date Funds.  Actually, he didn’t ask me exactly, because he was probably worried that I’d launch into a 10 minute lecture on the subject.  To be more accurate, he mentioned that he invested exclusively in a single Target Date Fund.  It seems he’s not alone.  According to researcher Elizabeth Stockton, 45% of 401K contributions now go to Target Date Funds, and she predicts that to increase to 90% by the year 2020.

Mindful investing is all about simple evidence-based investing practices like:

1. Using mindfulness to minimize reckless emotional investing decisions.
2. Buying and holding for the long term (at least 10 to 15 years), instead of trying to time the market.
3. Building an investment plan that takes advantage of the market return and not trying to somehow “beat the market”.
4. Using low-cost index funds, instead of trying to pick a few winning individual stocks out of a sea of losers.
5. Focusing on a simple and moderately diversified set of stock funds, and not trying to devise the ideal portfolio for an unpredictable future.
6. Including bond or cash “ballast” in a portfolio only when you start approaching retirement, and only in moderate amounts.

When my buddy mentioned his preference for Target Date Funds, it made me wonder whether this increasingly popular type of fund is consistent with mindful investing practices.  Before I dive into that question, I should briefly define Target Date Funds and how they work.

What’s the Target?

Target Date Funds (TDFs) attempt to address the complexities of retirement saving and investing with a one-stop-shopping solution.  The “target date” in TDFs is the year the investor intends to retire.  For example, if you intend to retire 32 years from today, you would invest in a TDF with a retirement target date of 2050.  The retirement year is often specified in the names of the TDFs, such as “Vanguard Target Retirement 2050 Fund”.

Fund managers shift the asset allocations in TDFs over time as the retirement date approaches, and sometimes the shift continues for a few years after the retirement date.  The trend of the shift is generally away from more volatile stocks and towards less volatile bonds or other forms of portfolio “ballast”.  The shift reduces the chances that an inopportune stock market crash will severely deplete your retirement savings right around the time you start living off those savings.  This so called “sequence of return risk” is one of the primary challenges facing investors as they transition into their retirement years, as I discuss more here.  Of course, the safety created by shifting towards ballast near retirement also reduces the portfolio’s overall returns.  There’s never a completely free lunch.

The main advantage of TDFs are their simplicity.  Rather, than having to figure out when and how much to shift your asset allocations over time, you just regularly buy TDF shares and the fund manager figures out the rest.  TDF managers usually execute this allocation dance by investing in other funds offered by the same company.  Essentially, TDFs are funds composed of annually changing combinations of other funds.

A Mindful Analysis

Using Target Date Funds (TDFs) is pretty simple, but is it mindful?  Looking at the numbered list of mindful investing practices above, we can easily see that TDFs check two of the mindful investing boxes:

1. TDFs might help you avoid reckless emotional investing decisions.  TDFs represent a simple but well-defined plan, where you invest in the TDF regularly, regardless of what the markets are doing.  That said, mindfulness techniques will still help you avoid departing from the plan and doing reckless things, like selling all your TDF shares during a crash and burying the money in the back yard.
2. A properly executed TDF-based plan is also inherently consistent with the concept of buying and holding for the long term and not attempting to time the market.

For the last four mindful investing practices, the picture is a little more complicated.  So, let’s look at each in turn.

3. Not Trying to Beat the Market

I’ve written copiously about the near impossibility of “beating the market” by striving for excess returns above and beyond the broad-market return that’s readily available using index funds.  Seeking excess returns is also sometimes called “active investing”, while using index funds is called “passive investing”.  I find those terms confusing, because there’s obviously a huge spectrum of more and less active styles of investing, and everyone makes “active” decisions in their own investing to some extent.  I prefer the terms “complex” versus “simple”.  But for our purposes today, most Target Date Funds (TDFs) can be reasonably classified as either active or passive based on whether the TDF invests mostly in index funds.

Only passive TDFs are consistent with the third mindful investing practice of not trying to beat the market.  Fortunately, the fund industry is offering ever more passive options.  As this graph from an excellent Morningstar Report shows, there are plenty of passive TDFs that mainly use index funds.

The expense ratio of a TDF is another clue to how actively the fund is managed.  In most cases, active TDFs will charge higher expenses, presumably to pay for all that “hard work” of searching for the choicest investment opportunities.  This brings us to the fourth mindful practice.

4. Low Costs

Mindful investing focuses on low costs, because costs eat into returns, and paradoxically, higher costs are often correlated with lower returns.  If you doubt this paradox, read this article.  So, what are the costs associated with Target Date Funds (TDFs)?  I developed this graph using data on dozens of TDFs from the same Morningstar Report.

The horizontal axis shows the TDF expense ratios, while the vertical axis shows a “Performance Rank”.  Morningstar ranked all the TDFs based on their three-year annualized returns.  The number one ranked TDF is the best performer in that period.  The best-performing and lowest-cost TDFs reside in the lower left-hand corner of the graph (circled in green).  There were also some highly ranked TDFs with moderately higher expense ratios (circled in brown).  But the Morningstar report reveals that these performance ranks jump around substantially over time.  So, there’s no guarantee that the top ranked funds of today will stay at the top tomorrow.  And consistent with the cost versus performance paradox, there are no high-cost and high-performing TDFs in the lower right-hand corner of the graph.

The graph also has a red diamond approximating the mindful investing approach that I’ve advocated on this website.  To plot the red diamond, I calculated the annualized costs and returns over the last 3 years for a portfolio of low-cost index funds with an asset allocation of 48% U.S. stocks, 20% foreign developed market stocks, 12% emerging market stocks, and 20% cash.  The mindful investing portfolio is not the very best performer here, but it has the lowest costs.

So, it seems like picking one of the five TDFs inside the green circle would be pretty consistent with mindful investing practices.  These TDFs have low costs, are most likely using passive index funds, and they’ve been fairly good performers in the past, although that’s no guarantee for the future.  However, the rest of the TDFs aren’t particularly mindful.

5. A Moderately Diversified Portfolio Focused on Stocks

I’ve argued that the “risks” associated with stocks are generally over-blown, particularly for folks who are more mindful and less emotionally reactive to stock market gyrations.  At the same time, history has shown that stocks have almost always greatly outperformed ballast assets (bonds and cash).  As a result, a mindful investing portfolio has a very high proportion of stocks to ballast.  The Morningstar Report has great statistics on the assets contained in Target Date Funds (TDFs).  This graph shows a handful of the most popular TDFs.

The bond allocations will be substantially higher for a 2020 fund as compared to a 2050 fund, which I discuss more below.  These bars show the average allocations of each company’s entire series of TDFs from the closest to farthest target dates.  So, these averages give a sense of how each company may favor certain asset types to a greater or lesser extent across their entire set of TDF offerings.  Also, the far right bar shows the Mindfully Investing asset allocation that is similarly averaged across my recommendations for younger and older investors.  (“Bonds” for the Mindfully Investing Approach are either bonds or cash depending on the prevailing bond yields, for reasons I’ve detailed here.)

All of these TDFs hold substantially more bonds than the Mindfully Investing approach.  And there’s a fairly large range of average bond allocations from 23% to 35%.  Of course this range only covers a handful of funds.  To assess the industry-wide range of allocations, this graph compiles the largest and smallest asset allocations of all the TDF companies in the Morningstar Report.

Across the entire industry, the average bond allocation ranges from 17% to 48%.  There are clearly widely divergent interpretations of the most appropriate asset allocations as retirement approaches.

Again, we see that TDFs can be more or less consistent with mindful investing practices, depending on which TDF you choose.  Because these are averages across funds with both near and far target dates, the bond percentages are even higher for TDFs nearing their target dates.  The shifting of allocations over time brings us to the next mindful practice.

6.  Moderate Ballast and Only around the Retirement Threshold

The degree to which asset allocations shift over time in Target Date Funds (TDFs) is often referred to as their “glide path”.  We can see why it’s called a glide path in this graph from Morningstar.

As the target date gets closer, the amount of stocks in the TDF (blue and purple here) “glides” down to a lower level in preparation for retirement.  The industry average bond and cash allocation for a TDF approaching the retirement date (using the statistics for 2020) is a whopping 50%, which is way beyond the Mindfully Investing recommendation of 20% ballast at retirement.

We can see the variation in glide paths across a handful of popular TDFs, as well as the industry-wide highest and lowest glide paths, in this graph using data from Morningstar and another TDF report from State Farm.

The vertical line at year zero is the target retirement date, where the stock allocations range from 9% to 65%.  Some of the more extreme TDFs are almost entirely bonds after retirement starts.  That’s a very safe glide path, but a portfolio composed mostly of low-return bonds will likely decrease your retirement spending budget dramatically.

In contrast, at the top of the graph is a blue line representing the Mindfully Investing approach, where the amount of ballast (cash or bonds) increases around the target date and then goes back to 100% stocks 10 years later.  As I’ve discussed before, experts like Michael Kitces and Wade Pfau have pointed out the merits of this “rising glide path” for stocks after retirement starts.  They’ve shown that a rising stock glide path can improve your chances of having enough money later in retirement.

Once again we see that not all TDFs are created equal, and none of the glide paths are entirely consistent with mindful investing practices.

Conclusions

It appears that Target Date Funds (TDFs) are partly consistent with mindful investing practices, but using them requires careful consideration.  Specifically, we’ve found that:

• All TDFs are generally consistent with non-emotional investing over the long term.
• Only “passive” TDFs that use mostly index funds avoid the trap of trying to “beat the market”.
• Only a few TDFs conform to the mindful practice of using low-cost funds that achieve performance similar to the readily available broad stock market return.
• None of the TDFs use the relatively lower bond/cash ballast proportions that match mindful investing practices.
• None of the TDFs have a rising glide path for stocks after retirement starts.

One possible decision could be to use a low-cost, passive TDF that has the highest stock proportions and glide path available.  This is a simple way to achieve a passable approximation of mindful investing.  I’ve discussed before that back-tests of these various ballast proportions and glide paths shows that the more traditional glide paths in TDFs can sometimes perform better than the rising glide path approach, depending on future market conditions.  Because no one can predict the future, this simple TDF decision is reasonable, if not ideally mindful.

Another option is to select a TDF with a much later target date than your actual expected retirement year.  In most cases, this will substantially boost your stock allocations as you approach your actual retirement date.  But it still won’t give you a rising stock glide path later in retirement.

A somewhat more complex way to use TDFs more mindfully would be to buy some additional stock index funds on the side, but this kind of defeats the original intent of TDFs as a one-stop investing solution.  Vanguard studied how folks use TDFs and found that there are “pure” TDF investors, who only invest in a single TDF, and “mixed” TDF investors, who use additional funds in their portfolios.  While TDFs are intended for “pure” investing, in fact, only 60% of TDF investors hold TDFs exclusively.  Because TDFs are an off-the-rack solution, it seems that in the real world many people further tailor TDFs to fit their specific needs.

The lesson here is that your investing plan should be comprehensive.  When considering TDFs, you should factor in the entirety of your retirement investments and income sources.  For example, if you expect Social Security to fulfill half of your spending needs in retirement, using a TDF that’s 90% bonds for the other half is extremely conservative.  Similarly, if you use a TDF in one account, and other types of funds in a second account, you need to calculate your stock/ballast proportions and changing glide path based on the sum of all accounts.

It turns out that Target Date Funds hit the mindfulness mark in some ways but not others.  Prudent TDF investing requires carefully considering many details.  So, you should ask yourself whether a do-it-yourself portfolio and glide path could be nearly as easy to implement, more specific to your situation, and could more effectively meet your long-term goals.