Why I Don’t Use Target Date Funds

Target-date retirement funds just surpassed the $1 trillion mark, according to Morningstar. This is good for investors, as most of the money is flowing in to low-cost funds that predominantly buy low-cost index funds.

Though I’m a big fan of these funds-of-funds as long as expenses are low, I own none, and rarely recommend them. Let me explain.

What Is A Target-Date Fund?

Target-date and balanced funds are funds-of-funds. Because there is an extra layer of funds, they are generally a bit more expensive, yet many are still very low cost. For example, the Schwab Target Date 2020 fund (SWYLX) has an annual expense ratio of 0.08% and invests in eight ultra-low cost Schwab ETFs.

Similarly, the iShares Moderate Allocation ETF (AOM) invests in seven low-cost iShares ETFs. In the examples above, the Schwab fund is about 46% in equities, while the iShares is about 41% in equities.

The difference between a target-date and balanced fund is that the target-date fund generally gets more conservative over time—more bonds than equity—while a balanced fund tries to maintain the allocations.

Harnessing Inertia

Markets aren’t predictable, but human behavior is. Stocks surge and people buy. Stocks plunge and people sell.

Buying more stocks after a plunge is incredibly hard. I can tell you that clicking “buy” in late 2008 and early 2009 was the hardest thing I’ve ever done in investing. It seemed like the end of capitalism was near, and perhaps that’s why even advisors as a whole timed markets poorly.

These funds actually do the painful work for you. Stocks plunge, and these vehicles must sell bonds to buy more stocks. Stocks surge, and they must sell stocks to buy more bonds. All you have to do is nothing, thus harnessing inertia.

You can minimize the pain by not looking at your portfolio, though that is not so easy to do. If you can resist the urge to panic and sell, the fund will rebalance for you, which may well be worth the extra fees. In fact, I call target-date retirement and balanced funds the first—and still likely the best—robo advisors around.

Lacking Tax Efficiency

My own portfolio happens to be 45% in equities and 55% in fixed income. So why don’t I just buy one of these funds and get on with my life? Because I strive to make more money after taxes, so where I locate assets is critical. Below is a general guide:

The above table gives you an idea of where I locate my assets. My stock-index funds are all in my taxable account, while my traditional IRAs and 401(k) are all in bond funds or CDs. I locate them that way because dividends on stock index funds are taxed at lower rates, and the capital gains can be deferred for decades, and even forever, if you pass on these holdings to your heirs, where they will get a step-up basis.

Even when you do pay taxes, the long-term capital gains rate is lower than ordinary income and is sometimes taxed at a zero percent rate, if your income is low enough in retirement. On the other hand, bonds, CDs and REIT income are taxed as ordinary income, which is generally at a higher rate.

If I haven’t convinced you yet, consider what happens to stock index funds in a tax-deferred account. You’ve taken what would have been a long-term capital gain and converted it to ordinary income. That is to say, when you take it out to live on, the IRS doesn’t allow you that preferable lower long-term capital gains rate. You pay taxes based on ordinary income.

My Advice

I’ve always said investing was simple, but I never said taxes were. Let’s face it: Most people save little outside their retirement accounts. For those investors, a low-cost target-date retirement or balanced fund is perfect. Set it and forget it … and let the powers of inertia and compounding work their magic.

Just understand the pros and cons of these funds. But if you have discipline and can spare some time to rebalance, buy the underlying funds directly and locate the assets in a more tax-efficient manner. Remember, taxes are fees too.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.