When Target-Date Funds Aren't the Best Solution

originally posted 3/2019

We are fans of target-date funds. They offer a simple, all-in-one investment solution that automatically adjusts over time—ideal for anyone who doesn’t want to worry about asset allocation or rebalancing. But while they can be a great option in the right context, there are situations where a target-date fund may not be the best fit.

Here are two scenarios where you might want to look for an alternative:

1) You are Investing in a Taxable (Brokerage) Account.

Target-date funds are commonly used in retirement accounts like 401(k)s and IRAs where taxes aren’t a concern until funds are withdrawn. But when it comes to a taxable brokerage account, the tax implications of your investment choices matter—and target-date funds can be tax-inefficient.

Here’s why:

Target-date funds are a single investment made up of multiple underlying funds. Take the Vanguard Target Retirement 2045 Fund (VTIVX), for example. The underlying holdings are:

• Total Stock Market Index Fund (tax-efficient)

• Total International Stock Index Fund (tax-efficient)

• Total Bond Market II Index Fund (not tax-efficient)

• Total International Bond Index Fund (not tax-efficient)

The bond components generate interest income taxed at ordinary income rates (which can be as high as 37%), making them less suitable for taxable accounts in many cases. Stocks, on the other hand, often benefit from lower long-term capital gains tax rates (0%–20%).

That’s why a more tax-efficient strategy often involves placing:

• Stocks in taxable (brokerage) accounts

• Bonds, CDs, and REITs in tax-advantaged accounts, such as 401(k)s or IRAs

There are always exceptions to the rule, but this is a general guide that should be considered along with the objectives of each account. When your portfolio spans multiple account types, coordinating investments across accounts can typically help minimize taxes and improve your after-tax return.

2) The Target-Date Fund Available to You Isn’t High Quality

Not all target-date funds are created equal. In employer-sponsored retirement plans, such as 401(k)s, your investment choices may be limited—and the target-date fund offered might not meet key criteria. When we evaluate a target-date fund, we look at three main factors:

Allocation

This refers to how much the fund invests in different asset classes like U.S. stocks, international stocks, bonds, REITs, or even commodities. Asset allocation is the biggest driver of long-term returns (it accounts for over 90% of portfolio performance), so it’s critical to get it right. Some funds take on more risk or include asset types that others don’t—make sure the allocation fits your needs.

Glide Path

The “glide path” determines how the fund shifts from stocks to bonds as you approach retirement. This transition happens gradually, but each fund handles it differently. Some settle at 20% stocks in retirement; others stay at 30%–40%. If you’re withdrawing from your portfolio in retirement, you’ll need enough stock exposure to stay ahead of inflation without taking on too much risk.

Costs

Fees vary significantly—even among funds with the same target year from the same company. For example, at one time I found one mutual fund company that offered several Target-Date 2045 funds with fees ranging from 0.08% to 0.75%. Over time, higher fees eat away at your returns, so cost should be a key part of your analysis.

The Bottom Line

If your primary retirement savings are in a 401(k) and the plan offers a well-diversified, low-cost target-date fund with a reasonable glide path, it’s likely a good choice.

But if you’re investing across multiple account types—or if the fund available to you doesn’t score well on the items above—it's worth considering a more customized portfolio strategy. Taxes, like fees, are a hidden cost that can erode your long-term returns. Understanding where each type of investment belongs—or working with someone who does—can help you keep more of what you earn.

Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients throughout San Diego county and nationwide. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.

Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning and ongoing impact-focused investment management in San Diego and nationwide. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.