Target Date Mutual Funds

Of all the things a person can have a love-hate relationship with, target-date mutual funds are probably the least likely to feature in a romantic comedy.

If you aren’t already familiar with target-date funds (TDFs), here’s how they work. A single target-date fund typically does what finance writers are always telling you to do: It owns a diversified mix of domestic stocks, international stocks, and bonds. The fund has a year in its name, so you might own the Mamstershares Target Retirement 2030 fund.

As time goes by, you have fewer working years in which to save and less ability to take investment risks without wrecking your retirement, so the fund slowly sells off its stocks and buys more bonds. The 2030 fund might own 80% stocks and 20% bonds today, and then gradually ease down to 50% stocks and 50% bonds by 2030. You don’t have to do anything to make this happen because you always stay in the same fund as it gradually changes beneath your feet. (Assuming dollars have feet, of course.)

This change over time is called the fund’s “glide path,” because if you graph it, it resembles a plane landing. Two 2030 funds from two different companies don’t necessarily have the same glide path. Just because you have set your retirement to take place during a specific year, doesn’t mean you have to choose the fund with your “official” number in it. “You may find that the fund that best fits your own tolerance for risk is the one typically intended for investors retiring 10 or 15 years earlier or later than you,” writes Mike Piper, author of many books on investing and creator of the Oblivious Investor blog.

Given that we live in an age when a YouTube kitten video can devolve into a comment flamewar 10,000 posts long, it’s no surprise that TDFs are controversial. I’ve written about the controversy, but much of the debate centers around what happens on, or near, the target date. To the average young or mid-career investor, this is about as relevant to your life as an early-bird special.

So, assuming you won’t be in line at Denny’s this afternoon at 4:30 (not that there’s anything wrong with that), let’s look at whether a TDF is appropriate for you today.

The default option

When you sign up for a 401(k) (or are automatically enrolled), there’s a short list of investment types that your boss can stick you into without permission. Target-date funds are the most popular of these default options. Among workplace plans administered by Vanguard, for example, 89% use TDFs as the default.

The result is widespread use of TDFs by young investors. According to the Employee Benefit Research, 59% of workers under 30 use TDFs, and 46% of those use only a TDF- they don’t mix it with any other funds in their 401(k).

This is great news because young workers without a lot of savings are exactly the people best served by TDFs.

When to use a TDF

A TDF is a simple approach to investing, and it’s most appropriate when your investing life is simple.

For most people, your investing life is simple when you’re young and just getting started. At this point, a TDF is fine. It’s plenty diversified and automatically rebalanced. Rebalancing (returning your portfolio to the appropriate allocation) is that thing investors are supposed to do every so often, but rarely do. At this stage in your life, your investment strategy isn’t nearly as important as your savings rate.

When not to use a TDF

The TDF in your 401(k) is too expensive. In my wife’s retirement plan, for example, the target-date funds have an annual expense ratio of 0.45%, while the plain-vanilla stock and bond funds cost less than half of that. It sounds like a small number, but the expenses come right out of your bottom line and compound over time.

Then again, if having multiple funds is going to cause you to play around with your investment mix all the time, that kind of fiddling could cost you a lot more than a fraction of a percentage point. High expenses suck, but there’s no shame in paying a little extra to avoid sabotaging yourself.

You have a taxable investment account. People who have taxable investment accounts generally have a high income (enough that they can max out a 401(k) and IRA and keep on saving), or they are doing something wrong ( passing up valuable tax-advantaged saving opportunities). If you’re in the latter category, smarten up. If you’re in the former, then you probably want to hold your bonds in the retirement account and your stocks in the taxable account, which is something you can’t do with a TDF.

Alternatively, says Piper, “An investor in a high tax bracket could benefit from using tax-exempt municipal bonds, rather than the taxable bonds included in a target retirement fund.”

You have a bunch of different retirement accounts. If you’re part of a couple, each of you might maintain a 401(k) and a Roth IRA. Good for you. If you have access to the same low-cost TDF in all four accounts, then congratulations: You must live on another planet, because this almost never happens. We Earth people are generally better off building a portfolio from the best investment options in each account.

A TDF isn’t perfect—nothing is—but it’s a lot better than, say, investing in company stock and having your company pull an Enron. It may feel “undiversified” to put all your money in a single fund, but it’s not. “With just one target retirement fund, you can achieve an extreme level of diversification,” says Mike Piper of the Oblivious Investor blog. You get thousands of securities from around the world. “In my opinion, that’s as diversified as anyone needs to be.”

Now, if you’ll excuse me, I have an appointment with some Moons Over My Hammy.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter@Mint_Mamster.