If you don’t want to miss out on millions of dollars as you’re investing toward retirement, learn why you might want to avoid target date or lifecycle funds!
It can be overwhelming trying to figure out what is the best way to invest and to choose from thousands of stocks and funds in order to save and invest toward retirement.
While the answer isn’t a one-size-fits-all because everyone has different investing needs and goals, but it’s important to know your investment options. I’ll help you avoid the one mistake that could be costing you millions of dollars over the course of an investing lifetime.
You may want to consider avoiding or allocating less in a target date fund or aka lifecycle fund or aka age-based fund because these types of funds have been under-performing a low expense ratio, passive index fund such as the S&P 500.
Whether you’re investing for the first time or you’ve already been investing, you may have picked up a target date fund (TDF) somewhere along the way because some employers automatically enroll you into a TDF in your 401k. You might have even invested in a lifecycle fund in your Roth IRA or other investment vehicles.
The TDF is often closely aligned with your target retirement year or age. The standard retirement age is 65 so if you’re a millennial like I am you may have gotten a lifecycle fund for 2055 or 2060.
It’s easy to understand the appeal of a TDF because all you have to do is add 65 to your birth year and match that with the next closest TDF year. Boom, done, simple — retirement’s taken care of! But not so fast!
Target Date Fund Pros: 1) Autopilot investing, 2) All-In-One Assets, 3) Simple Approach, and 4) Plenty of Diversification.
TDF Cons: 1) Higher Expense Ratio Than S&P 500 Index Funds, 2) Asset Allocations are not flexible, 3) Not Inflation-Proof, 4) Future Results Are Not Guaranteed, 5) Too Much Diversification.
Lifecycle funds are like funds of funds, and have attributes that are somewhere in between an actively managed fund and a passive index fund. The target date fund assets are allocated in a combination of US equities, international stocks, bonds, and money market or short-term funds.
Typical TDFs will be allocated toward “riskier” equity concentration for younger investors, and the allocation will gradually increase in the more “conservative” bond funds as we get older.
I show an example as to if we are investing in Fidelity’s Freedom funds and what types of asset allocations we might expect if we invested in a TDF. I show how when we’re younger the lifecycle fund tends to be about 90% equities and 10% bonds, and then by the time we are retiring at age 65 the lifecycle fund moves to 57% equities and 43% bonds, as an example. With bond yields super low, I question whether having any bonds in one’s portfolio is wise.
While the first TDFs were created in the early 1990s, most modern TDFs have been around since the mid-2000s so their investment track record is somewhat limited. It’s generally been positive for most investors over the last 15 years. You couldn’t help but do well if you were invested in a TDF over the last 15 years, so what’s the problem?
The two main issues are that target date funds have higher expense ratios and below average returns compared to a low cost S&P 500 passive index fund. The difference of 5% less in returns for TDFs versus the S&P 500 can be incredibly significant!
In 2021, the Fidelity Freedom 2055 Fund returned about 16.5% compared to the S&P 500 returning 28.7%. Over the life of the 2055 Fund, it has returned about 10.2% compared to the S&P 500 returning 15.2%.
The Freedom 2055 Fund (FDEEX) has an expense ratio of 0.75% compared to Fidelity’s S&P 500 fund (FXAIX) of 0.015%. If you invested $30,000 in either fund, the annual fees for FDEEX would be $225 vs the FXAIX annual fees of $4.50. So it’s almost no contest between the Freedom Fund vs S&P 500 Index Fund, the latter wins hands down, and research supports this finding.
So if you invested $6,000 in your Roth IRA every year for 35 years and only put it in the S&P 500 index fund, you would have arrived at over $7 million compared to the Freedom Fund earning $2 million — a difference of over $5 million dollars!!!
The way I see it if you don’t want to settle for below average returns with higher expenses are the two main ways you can go that are both consistent with what Warren Buffett has suggested.
You can either:
1) Buffett said that the best thing to do for most people is to invest in the S&P 500 index fund. And/or
2) Study individual companies’ stocks and invest in these wonderful companies at a fair price.
Buffett achieved above average returns by investing in individual companies and stocks, so that’s the path I’m taking. As long as you avoid target date funds, the S&P 500 has historically proven to perform better. Of course none of this is guaranteed to continue in the future, but there are worse ways you could go about investing. So choose your investing journey wisely and enjoy!
If you’re interested in learning how to take control of your finances and start becoming an investor like Warren Buffett, check out my free PDF guide.
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