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Off Target

Adam M. Grossman  |  September 23, 2018

ALBERT EINSTEIN reportedly once said, “Everything should be made as simple as possible, but not simpler,” or words to that effect.

When it comes to investing, I have always believed that the simplest approach is the best approach. But in recent years, a new type of investment has, I believe, crossed over into the “too simple” category.

This new type of investment: target-date mutual funds. If you aren’t familiar with them, target-date funds are mutual funds that typically buy other funds. For example, a target-date fund might be comprised of stock funds and bond funds, with the specific mix geared to one’s expected retirement date, which is the target date specified in the fund’s name. For workers early in their career, the mix might be 90% stocks and 10% bonds. But over time, as the worker gets closer to retirement, the composition will shift, automatically becoming more conservative. Owing to their simplicity, target-date funds have seen sharp growth over the past 10 years.

In theory, this type of all-in-one offering is very appealing. But there are four reasons I would be cautious about investing in one:

First, target-date funds make it difficult to know what you own. Research has shown that the most important driver of a portfolio’s risk and return is its asset allocation—that is, the mix of stocks, bonds and other assets. As a result, asset allocation is arguably the most important portfolio metric to monitor. But target-date funds make it difficult to track this key metric because they contain a mix of asset classes—and, worse yet, a mix that’s constantly changing.

Second, the composition of these funds may be a poor fit. Choosing an investment based on your age is like choosing clothing based on your age. It might be okay when you’re an infant or a toddler, but it makes little sense as you get older. Yes, there is some correlation between age and investment needs, but your age is just one piece of the puzzle. Other factors include: the size and composition of your other assets, your eligibility for Social Security or a pension, your spouse’s retirement timetable, whether you expect an inheritance and much more.

Third, they complicate tax planning at every stage of your career. Suppose you have a 401(k) and a taxable account and you want to purchase $1,000 of stocks and $1,000 of bonds. Should you put the stocks in your 401(k) and the bonds in your taxable account, or the other way around?

Even though you would be purchasing the same investments in either case, the decision would have a big impact on your tax bill. In many cases, investors will find they’re better off pursuing tax-efficient stock strategies in their taxable account, while holding bonds in their retirement account. This sort of asset location is a valuable tax planning strategy. But by creating an inseparable link between stocks and bonds, target-date funds hamper your ability to employ it.

These tax problems become especially thorny as you get older—assuming you hold a target-date fund in a regular taxable account. The funds assume you’ll want to sell stocks and buy bonds as you get closer to retirement. For many people, this will make sense. But suppose you don’t want to do that. Maybe your portfolio is large enough that you can afford more risk. Or maybe you have a pension or other secure sources of retirement income. In all of these cases, the target-date fund will be working against you, selling assets and generating unnecessary tax bills.

Target-date funds might also work against you once you enter retirement—again, assuming you hold your fund in a taxable account. Suppose you want to withdraw $50,000 to meet your expenses this year. To minimize the tax impact, you would want to sell investments that have the smallest unrealized gains, and perhaps simultaneously donate to charity those investments with the greatest unrealized gains. For most people, this might mean selling bonds and donating stocks. This is a powerful strategy. But when you own a target-date fund, your ability to do this is limited because of that inseparable link between stocks and bonds.

Finally, target-date funds often carry higher fees. In many cases, target-date funds are no more expensive than their component parts. That’s as it should be. But I have seen several cases in which target-date funds were considerably more expensive than their constituent parts. Like paying $3 to buy two $1 bills, this sounds illogical and I would even call it unfair, but it happens.

Fortunately, there’s a solution: If you are considering a target-date fund, instead simply purchase the constituent funds independently. While this will require a little more effort, I believe it’s well worth it.

Adam M. Grossman’s previous blogs include Just Like WarrenAny Alternative and Buy What You Know. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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