Target-Date Funds vs. S&P 500 Indexing: An Overview

Target-date funds have become very popular in 401(k) retirement plans, largely due to their convenience. At first blush, they may seem like an obvious choice for most workers; however, they come with certain drawbacks compared to S&P 500 Index funds.

Key Takeaways

  • Target-date funds are investments tailored to a specific age bracket, where the idea is to have the content of the fund gradually change as investors age in order to maintain a suitable risk level.
  • Target-date funds are typically funds of funds, meaning they are basically baskets holding other funds from the same company.
  • Index funds, in general, are purely mechanical constructs that duplicate a market segment.
  • What sets the S&P 500 Index apart is the selection process; it tends to be slightly less volatile than the total market index fund.

Target-Date Funds

Target-date funds are investments tailored to a specific age bracket, where the idea is to have the content of the fund gradually change as investors age in order to maintain a suitable risk level.

For example, a target-date fund may be intended for people wishing to retire in 2045. With 30 years to retirement, the fund is initially heavily slanted toward growth stock. It may also contain some income stock and bonds for diversification. By 2035, the fund dramatically decreases the growth stock focus and instead splits the majority of the holdings between safer income stocks and bonds. Finally, as the time for payout approaches in 2045, the fund has all but completed the shift toward safety and contains mostly bonds.

The advantage of this type of fund is convenience. A person can go through his entire working life without ever having to lift a finger beyond checking off the initial box. On the same note, the automatic decrease in risk prevents an unobservant investor from losing a big chunk of his nest egg if the stock market crashes right before his retirement.

The downside is that convenience comes with a price. Target-date funds are typically funds of funds, meaning they are basically baskets holding other funds from the same company. In the fictional fund example outlined above, this could mean the target-date fund places 60% of the money in Fund A, 30% in Fund B and 10% in Fund C. Each of the three funds charges normal fees.

But since the investor did not buy them individually, he is also paying another layer of fees for the target-date fund. If all three funds charge 0.5% per year, and the target-date fund also charges 0.5% per year, the investor ends up paying extra in total fees.

Another concern with target-date funds is the funds typically have a small but largely unnecessary portion of safe investments even when the target date is decades away. The argument is that the10% to 20% typically placed in bonds do not generate nearly as much return as a pure growth stock investment. With a horizon of 20 to 30 years, the opportunity cost of such inferior asset returns becomes significant.

S&P 500 Indexing

Index funds, in general, are purely mechanical constructs that duplicate a market segment. What sets the S&P 500 Index apart is the selection process. For example, a domestic total market index fund includes the big companies found in the S&P 500 and thus has significant overlap, but it also has a number of small- and mid-cap companies, making the basket many times larger.

Unfortunately, the total market fund is fairly undiscriminating and may contain a number of holdings that are less liquid, or more than 50% of the equity being non-publicly traded; economically unviable due to ongoing losses; and otherwise unsuitable for inclusion in the index.

By contrast, the S&P 500 is determined by a committee of experts at Standard & Poor's, where each asset is fully viable and easily trackable. Since the S&P 500 is more refined, it tends to be slightly less volatile than the total market index fund, excluding the small-cap assets, but overall performance has been very similar over the years.

Special Considerations

Since there is no management team and staff of analysts, index fund fees are dramatically lower than those of actively managed funds. Diversification is naturally very strong since buying an S&P 500 Index fund means you are buying a stake in 500 different companies all at once. Most actively managed funds have fewer holdings, making a potential implosion of one particular stock much more tangible in such situations.

The downside of an S&P 500 Index fund is it does not change over time. A young person may want to opt for riskier funds that have a higher potential for superior returns. Meanwhile, a person close to retirement has to gradually sell S&P 500 Index fund shares and manually shift the portfolio in a suitable income-focused direction.