Do Target Date Funds Hit the Mark?

W. Ben Utley, CFP; Lawrence B. Keller, CFP, CLU, ChFC, RHU, LUTCF

October 2016, Vol 6, No 10 - Financial Management


Physicians seem to have a natural affinity for complexity. That’s a good thing for patients with difficult diagnoses, but it’s a prescription for disaster when it comes to investing. Owning a myriad of securities spread across a dozen or more financial accounts usually means more taxes, more transaction costs, less clarity, and more time spent on investing.

Time Well Spent?

It is this last bit, the time spent, that is the problem. Studies show that paying too much attention to the markets and your investments induces you to trade more often, and every time you trade, you run the risk of making a bad decision. Trading and “managing accounts” gives the illusion of control but usually delivers subpar results, studies show.

September 2016 marks the 40-year anniversary of the first index mutual fund, the Vanguard Index 500 Fund. It was Vanguard founder John Bogle who once said, “Don’t just do something, stand there.” This has proved to be some of the best advice ever given for physicians who owned the right investments in the first place.

What Is the Right Investment for the Next 40 Years?

This question cannot be answered. One thing is for certain, though: if an investment strategy is going to weather all the shocks of 4 decades worth of political change and economic upheaval, it has got to be diversified, very diversified.

Today it’s easier than ever to buy 1 or 2 mutual funds and hold those funds forever, knowing that you have made the right move.

What we are talking about is a mutual fund of mutual funds (aka a “fund of funds”). Although this may not ring a bell, the words “target-date retirement fund” are heard more loudly now than ever before as the likes of Vanguard, Fidelity, and T. Rowe Price have brought them to 401(k) accounts everywhere. In fact, these funds are so much a “best practice,” that they are often the qualified default investment option for many qualified plans. That means that if you are newly enrolled in a 401(k) plan, and you fail to make an explicit investment choice, you will likely wind up with a target-date fund geared toward your age 65.

How the Funds Work

Target-date retirement funds own a mix of stock mutual funds and bond mutual funds, and that mix shifts gradually over time, becoming more conservative every year. For example, a physician in his or her mid-30s may own the Target Retirement 2045 Fund, which starts off owning mostly equities today, then shifts to a balance of stocks and bonds at age 65, and grows even more conservative as that doctor approaches age 80, when the fund holds mostly bonds.

When you look under the hood of these target-date funds, you can find a variety of exposure, including stocks of large, well-respected US blue-chip companies, tiny microcap stocks you have never heard of that will be tomorrow’s Google or Apple, international stocks, emerging market stocks, and even real estate investment trusts. All target-date funds will own bonds during their glide from aggressive to conservative, and these may include US treasuries, corporate bonds, emerging market bonds, TIPS (Treasury Inflation-Protected Securities), and even floating rate bonds. Some target-date funds will also own commodities.

One of the best-known target retirement funds, the Vanguard Target Retirement series, owns 4 of Vanguard’s “total” funds, including their Total Stock Market Index, Total International Stock Index, Total Bond Market Index, and Total International Bond Index funds. That last fund was added to the lineup only a few years ago.

Investors who own these funds are invested in practically all the stocks and all the bonds available, which means they should either worry about everything or nothing at all, and worry has never been as profitable as optimism.

So what does this worry-free investing cost? With index-based target-date funds, the cost is very, very low. For example, a $100,000 investment usually costs approximately $150 annually, or $0.41 daily. Professional management, uber-diversification, and peace of mind can be had for less than the price of a cup of coffee. You don’t even need to pay an investment advisor to “manage” it for you, because it is already managed.

Not a Great Fit for Every Case

There are at least 2 situations that are not a great fit for a target-date fund approach to investing. The first case is money invested in a taxable account, such as a joint, individual, or trust account. In these accounts, the income from bonds held inside the mutual fund is taxed as ordinary income. For physicians in high tax brackets and high-tax states, such as California, New York, Wisconsin, and Minnesota, this may mean sacrificing 50% of the interest to the “tax man.”

The solution for these situations is to own 2 funds. The first fund can be a tax-exempt bond fund, maybe a fund that holds bonds issued by the state where you live, so that the interest paid is exempt from federal and state income tax. The second fund may be a global stock fund, such as the Vanguard Total World Stock Index or the DFA Global Equity Fund, both passively managed funds that tend to be naturally tax-efficient. Physicians can combine these funds in any ratio to match their appetite for risk.

The other case in which a target-date fund may not be a good fit is a person who wants a steady and unchanging exposure to risk, meaning that the mix of stocks and bonds does not change as you age. For this, there is another category of funds-of-funds known as “life stage” funds. With these funds, investors usually have a choice of aggressive, moderately aggressive, balanced, or conservative funds that own a static ratio of stocks and bonds, usually ranging from 80% stocks and 20% bonds and all the way down to 20% stocks and 80% bonds.

Look Before You Leap

Although all retirement target-date funds work essentially the same way, they are not all the same. The underlying funds can vary greatly. For example, actively managed funds from Fidelity may lean toward growth stocks, whereas T. Rowe Price’s target funds hold junk bonds in their fixed-income sleeve, something not seen in the Vanguard funds, which take a middle-of-the-road approach.

The way in which each fund family shifts the investment mix over time, known as the “glidepath,” varies substantially. Although all 3 company’s funds begin with a 90/10 mix of stocks and bonds, Vanguard and T. Rowe Price begin adding more bonds 25 years before the retirement target date, whereas Fidelity begins adding bonds 20 years before retirement. The retirement end point allocation varies too. Fidelity and Vanguard hold a 50/50 allocation at retirement, whereas T. Rowe Price is 60/40.

In most cases, you will not get a choice about glidepaths, because the suite of target-date funds is chosen by a plan administrator, and there is usually only one suite from one company.

Conclusion

Although physicians often come up with far more elaborate ways to invest, it would be difficult to come up with a strategy of investing that is as simple, practical, and cost-effective as investing in a fund-of-index-funds. And this way of investing can save you more than time. It can avoid the mistakes that lead to worse outcomes.