We really like target-date funds. They are a simple and convenient solution for those that want an all-in-one investment strategy and don't want to worry about rebalancing. However, there are two situations when they aren't the best choice.
1) You have a taxable account (such as a brokerage account).
The maximum amount you can save to a qualified account (401k or TSP) in 2019 is $19K ($25K for those over 50). If you are fortunate enough to be able to save more than that each year, you may find yourself starting to save to a taxable account. Unlike your 401k, earnings in brokerage accounts are taxed every year on your tax return as ordinary income and capital gains. Therefore, the investments you place in the taxable account have to be tax-efficient otherwise taxes will reduce your return. The problem - target-date funds aren't tax efficient.
A target-date fund is one ticker that comprises of a series of underlying investments. For example, here are the components of Vanguard's Target Retirement 2045 Fund (VTIVX as of 3/23/2019):
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)
In general, bonds, CDs and real estate investment trusts (REITs) generate income that is taxed at ordinary rates (up to 37% for some) whereas income from stocks will typically be taxed at a lower, capital gains rate (0%-20%). Therefore, you benefit from putting tax-efficient investments in the Brokerage account, like stocks, and investments that are not tax-efficient (bonds, CDs and REITs) into the 401k or IRA.
2) The target-date fund available to you isn't adequate.
You have limited investment options when you invest in your 401k plan unless there is a self-directed brokerage option. If a target-date fund is one of your options, we analyze it for the following factors:
Allocation is the percentage invested in a given asset class, such as stocks or bonds. Some target-date funds hold a high percentage in international and some have REITs or commodities while others don't. More than 90% of your portfolio's performance is due to asset allocation - you have to get that piece of the puzzle right. .
All target-date funds have a glide path - meaning they start out aggressively, invested mostly in stocks, and become more conservative, invested in bonds, as you near your retirement year. That change doesn't happen abruptly - it is a smooth transition that happens over time. Every investment company handles this transition differently. For those in retirement and withdrawing from their portfolio, some funds settle at about 20% stock while others hold 30-40%. You don't want to take on unnecessary risk, but you need enough exposure to stocks that you are able to keep up with inflation in the long-term.
Costs vary widely among target-date funds. The same company can offer different target date funds for the same year but with different strategies and costs. Fidelity, for example, has three Target-Date 2045 Funds that range from .08% per year in cost to .75%. Schwab has two sets of target date fund families each with different strategies and costs. Fees reduce your return over time so they need to be a part of the analysis.
Overall, if most of your money is in your 401k at work and you have the ability to save to a target-date fund that meets our three criteria (diversified allocation, appropriate glide-path, low-cost), use it. If you have multiple accounts with different tax characteristics (such as a 401k and a Brokerage account), a target-date fund may not be the best strategy. Taxes are like any expense - they eat away at your return over time. Make sure you understand the tax implications or hire someone that does.