Should You Invest in Vanguard Target Retirement Funds?

My company made Vanguard Target Retirement Funds available for our 401k accounts about two years ago. However, I have not used them since I prefer to manually manage my portfolio using traditional funds that include bond, large-cap, small-cap, international stock, and REIT funds. However, Target Retirement Funds are not without merits. In fact, I’ve been using Target Retirement Funds for my SEP IRA.

What are Target Retirement Funds?

A target retirement fund is a mutual fund designed with a specific retirement year in mind (usually in 5 year increments). For example, if you are 35 years old now and you’d like to retire when you turn 65, you can invest in a 2040 Target Retirement Fund. As the fund approaches the target retirement year, the fund allocation becomes more conservative — investing in more fixed-income investments — to decrease risk and preserve capital.

Here’s Vanguard 2010 versus 2040 to give you and idea on how the fund changes over time:

Vanguard Target Retirement 2010 (VTENX)

vanguard-2010

Vanguard Target Retirement 2040 (VFORX)

vanguard-2040

Roughly speaking, Vanguard 2010 is more conservative with a 45% allocation to bonds versus only 10% bonds for Vanguard 2040. As time progress, Vanguard 2040 will slowly increase its bonds position.

The Pluses and Minuses of Target Retirement Funds

The Pluses

Personally, I think there are two things that make Target Retirement Funds attractive.

  • Easy  This is one of those buy it and forget it investments. You just have to figure out when you want to retire and buy the fund with the closest retirement date. As you invest more money into your 401k, you’ll automatically add to your position without having to worry about asset allocation and regularly rebalancing your portfolio. This is perfect place to invest if you have uninvested money sitting in your 401k account.

Diversification — Target retirement funds help you automatically diversify between the two most important asset classes — equity and fixed-income. Additionally, Target Retirement Funds are what The Street calls “Funds of Funds“. This means they invest in other mutual funds, making them a very diversified investment. For example, Vanguard 2040 is comprised of the following funds:

Fund Allocation Expense Ratio
Vanguard Total Stk Market Idx Fd Inc 72.08% 0.15%
Vanguard Total Bond Market Index 10.11% 0.19%
Vanguard European Stock Index 9.74% 0.22%
Vanguard Pacific Stock Index 4.37% 0.22%
Vanguard Emerging Mkts Stock Idx 3.66% 0.37%

The Minuses

There are also a few things that make Target Retirement Funds unattractive:

  • Double Fee Structure – Target Retirement Funds are Funds of Funds. For some funds, you are paying for both the fund’s direct expense, and indirectly for all of the underlying funds’ expenses as well. Note: Vanguard is an exception to this rule. The 0.21% expense ratio is the total expense you pay.
  • Skewing – Because the fund is designed to be optimally allocated for your target retirement date, you could potentially skew your portfolio if you own a Target Retirement Fund and also buy other mutual funds to “enhance” the portfolio. For example, if you have more equity investments in addition to a Target Retirement Fund, your overall portfolio is more aggressive. On the other hand owning fixed-income investments would do the opposite to your portfolio, skewing it the conservative side.
  • Hard To Evaluate — Because Target Retirement Funds are relatively new, they don’t have long-term track records. Secondly, it’s hard to compare them to an index like the S&P 500 because they are diversified, including both equity and fixed-income investments. Third, it’s hard to compare Target Retirement Funds from different companies like Vanguard and Fidelity without spending time digging into each fund. In other words, a 2040 fund from one company could be very different from a 2040 fund from another.
  • Generic – Although it’s nice to be able to simply pick out the closest retirement date, these funds do not take your individual financial goals or risk tolerance level into account. That said, you can usually find ways to personalize your portfolio a bit. If you have higher risk tolerance or need to invest more aggressively to reach your goals, you can buy a higher-dated fund (such as a 2050 fund if you want to retire in 2040) to increase your “expected” return.

Other Considerations When Buying Target Retirement Funds

There are also a few other things you may want to consider when investing in Target Retirement Funds.

Your Existing Portfolio

As mentioned before, owning other investments in addition to a Target Retirement Fund can actually work against you due to skewing. This means that if you want to get into a Target Retirement Fund you may have to consider liquidating your existing portfolio. At the very least, be very careful with its asset allocation. Portfolio liquidation can be a problem for investors who have accumulated a large amount of assets. Trading costs and potential tax consequences (especially for investments in taxable accounts) can erode returns and cause financial strain.

Actively Managed Fund

Some Target Retirement Funds are actively managed, and there’s the potential that your fund manager may stray from the stated investment policy. For example, he or she may be investing more aggressively than stated in order to outperform other Target Retirement Funds. This is especially worrisome for investors who are near their retirements.

Note: this is not the case with Vanguard Target Retirement Funds, which are made up of index funds.

Conclusion

Personally, I remain undecided about whether or not I should leverage a Target Retirement Fund. I enjoy managing my own portfolio, and there are some disadvantages to consider. However, I think investing in a Target Retirement Fund in my non-401k accounts might be a good option; it will at least make life simpler. Also, I think Target Retirement Funds are good for people who don’t want to bother managing the portfolio on their own. A target date fund is far better than neglecting the portfolio altogether.

What are your thoughts on Target Retirement Funds? Do you invest in them? What do you like or dislike about them?

About the Author

By , on Dec 19, 2008
Pinyo
Pinyo is the owner of Moolanomy Personal Finance. He is a licensed Realtor specializing in residential homes in the Northern Virginia area. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, and financial literacy author.

Best Low Cost Stock Brokers

Featured Articles

Leave Your Comment (23 Comments)

  1. Matt Turner says:

    The use of “units” as value variables, really makes for some sneaky accounting and fee collection.
    Anyone offering a Vanguard Target Retirement Fund is themselves making money off of selling it, and companies are pouring their employee’s retirement accounts into it without those employees knowing anything about it. Sign here, they say.

  2. Pinyo says:

    @Dan – Depending on the transaction fees (if any) there might be a more cost effective strategy. Also, take a look at this article as it may help you: Strategy to Take Money Out of Your Retirement Plans After You Retire

    @Peter – 4% is just a rule of thumb and it’s highly dependent on how your investment performs. Take a look at this article: What is a Safe Withdrawal Rate in Retirement?

  3. PETER LETIZIA says:

    Is the 4% withdrawal figure set to maybe assure that funds will never run out; or is there a target time limit. If a person expects to live 20 years after retirement, what percentage would he withdraw.

  4. Dan says:

    I am retiring in a few months and am considering “bucket strategizing” within the Vanguard Target accounts. For example 30% in 2015, 30% in 2020 and 30% in 2025 etc and withdraw approx 4% from each for my living expenses. My thought would be that I would be covered for market ups and downs. Any thoughts/critcisms?

  5. Pinyo says:

    @Peter – Yes, target fund do continue to work after the “retirement date”. Even when you about to start your retirement, you still have 20-30 more years to worry about, so it’s a good idea to learn. If you’re unsure, start by learning about the basis like asset allocation and start investing with index funds, or target date funds.

    Depending on how much money you have, you may want to seek out a financial planner.

  6. Peter Letizia says:

    I’m still trying to figure out where/how to invest after retirement. Does a target fund still work after the retirement date? I have less than two years to go.

  7. @Tom: It really depends on your personal situation. The Target Retirement Funds will just invest the funds for you in a set pattern. There isn’t any guidance in terms of how much to withdraw out as income and so on. I would consult with a Certified Financial Planner that will put together a financial plan for you on a fee-only basis.

  8. tom vecchio says:

    I have been considering the Asset Management service at Vanguard because I am 87 and preparing for my eventual demise and transfer to my 67 year old wife, who is not very financially savvy.Suddenly, the idea of getting into their 2010 Retirement fund instead, without the 0.7% management fee, and similar diversification looks very appealing. Any comments?

  9. Kevin says:

    @Dave Smith: That’s a great point that I’ve never thought of. If you have a less financially savvy spouse the easier things can be made, the better.

  10. Dave Smith says:

    I currently manage my own portfolio using the same funds as the Target Ret. Funds, but am considering switching to the Target Ret. 2020 for our IRAs for one reason: my wife is not as financially savy as I am, and if I die before she does, this would make things a whole lot easier for her. I would not use TR20 in our taxable account, however, as I prefer to use munis for the bond portion here. Only one thing I don’t like about The TR Funds: they’re a little light on mid/small caps. I currently hold a percentage of my stock money in the Vanguard Tax Managed Small Cap Fund to make up for this, and would continue to do so if I go with the TR Fund. This does, however, slightly tip my overall stock/bond ratio more toward stocks.

  11. Mark LaPointe says:

    It appears that Fidelity matches the practice referenced above at Vanguard. Look at its prospectus for the Fidelity Freedom 2030 retirement fund (or any of the others). They charge no management nor 12b-1 fees, but do pass through the expense ratio of the underlying funds. Further,
    http://www.investopedia.com/te.....z1d3sPznbV says it’s now a requirement to name the double-dipping fees if any:

    “What Does Acquired Fund Fees And Expenses – AFFE Mean?
    A line item in a fund-of-funds’ prospectus that shows the operating expenses of the underlying funds. This became a requirement as of January 2007 and this information is found beneath the ‘Fees and Expenses’ heading.”

  12. Pinyo says:

    @WisdomBread – Yes, it was confusing to me too and that why I was corrected by my readers.

  13. WisdomBread says:

    Oh…i see…
    They have 0% “Ratio of Expenses to Average Net Assets” in the Financial Highlights table, which means
    “Acquired Fund Fees and Expenses” is all they take for “Annual Fund Operating Expenses.”
    They don’t double-charge.

  14. WisdomBread says:

    The below seems to indicate Vanguard doesn’t double-charge.

    “Although the Fund is not expected to incur any net expenses directly, the Fund’s shareholders indirectly bear the expenses of the underlying Vanguard funds (the Acquired Funds) in which the Fund invests. These expenses, along with the transaction costs (i.e., purchase and redemption fees), if any, imposed on the Fund by the Acquired Funds, are reflected below in the line item for “Acquired Fund Fees and Expenses.”

    However, they also indicated with fine print under “Annual Fund Operating Expenses”

    “the Total Annual Fund Operating Expenses shown in this table do not correlate to the expense ratio shown in the Financial Highlights table because that ratio does not include the Acquired Fund Fees and Expenses.”

    which, taken together, seems to say they do double charge?

  15. Pinyo says:

    @MITBeta — That’s a very good point about TRF. Thank you for adding that.

  16. MITBeta says:

    Another good reason to use Target Retirement Funds is that you need a substantial portfolio value to properly allocate and diversify. The minimum to get into a Vanguard TRF is $3000. But the minimum to buy into all of those funds separately is $15,000 — and that just gives you equal ownership in those 5 funds. You’d need $82,000 to assemble the same portfolio outside of the TRF.

    So TRFs are a great way to get started as an investor, and once a large enough portfolio is built, one can start to customize.

  17. Kevin says:

    Came just to point out what dangerman pointed out. With Vanguard, your 0.21% expense ratio is all you pay.

    Another reason that Vanguard is simply the best investment company out there.

    Plus gradually shifting from stocks to bonds without having to do much portfolio tweaking is an attractive option to many (myself included).

    Also, at least with Vanguard, you get a little bit of instant diversification when you first start (stocks/int’l stocks/bonds in the mix).

  18. Pinyo says:

    @PT Money – Based on the correction by Dangerman, not all Target Retirement Funds charge double-fee. However, you’ll have to read the prospectus very carefully. For example, Vanguard funds do not charge double fee.

    But here is another explanation of the double-fee. Some fund will charge you an expense ratio of say 0.5% and use the money to invest in other funds. These other funds, or underlying funds, also have their own expense ratio which is taken out of their total return. In essence, you are paying the expense ratio twice — once for the “Fund of Funds” and again for the underlying funds.

    @Dangerman — Thank you. I did further research and you’re correct. Vanguard Target Retirement Funds do not double charge.

  19. Dangerman says:

    “you are paying for both the fund’s direct expense, and indirectly for all of the underlying funds’ expenses as well.”

    WRONG! In the case of Vanguard, this is 100% wrong. Every Vanguard Target fund prospectus states “Although the Fund is not expected to incur any net expenses directly, the Fund’s shareholders indirectly bear the expenses of the underlying Vanguard funds (the Acquired Funds) in which the Fund invests.” The expense ratio is ONLY the costs of the underlying funds, NOT an extra on top.

    See also http://www.bargaineering.com/a.....ained.html

    This deserves a correction.

  20. Adam says:

    Great job on this! More and more people are investing in these in their 401(k) because they are easy. Although this may not be the best move, at least they are not leaving it in the default money market account. I also like the fact that many 401(k)s are making these target-date funds the new default fund. It will help out individuals who would otherwise leave their money in the money market account due to lack of education. Which is something else companies have to work on: educating their employees.

  21. Mr. GoTo says:

    Another reason not to use target date retirement funds is if you do not subscribe to the theory that the best asset allocation strategy requires a gradual transition from equities to bonds and cash purely as a function of age. I for one do not think that is the best strategy to provide a stable standard of living in the pre- and post-retirement phases.

  22. PT Money says:

    I’m currently investing in a TRF: Schwab Plan Retirement Trust 2040. Have been for about a year now. Expense ratio is .54 of fund assets. But I don’t see any “funds within funds” expense. Can someone please show me what that is? And how come I never see these expenses on my statement?

    Investing education is a hurdle I’ll admit that I need to get over, but it’s frustrating when you can’t see things clearly, b/c investment firms make it difficult.

  23. Jeff Rose says:

    @ Pinyo- You are right to stay away. Target date funds are one of the biggest ripoffs in the industry. Sure, they make it easy for the uneducated investor, but at what price. I’ve seen target date funds with expense ratios over 2%. Top that with minimal performance and you have the epitome of a “lemon”. Great article. Hope many readers find it.

Leave a Reply

Your email address will not be published. Required fields are marked *

*

Disclaimer

The information on this site is strictly the author's opinion. It does NOT constitute financial, legal, or other advice of any kind. You should consult with a certified adviser for advice to your specific circumstances.

While we try to ensure that the information on this site is accurate at the time of publication, information about third party products and services do change without notice. Please visit the official site for up-to-date information.

For additional information, please review our legal disclaimers and privacy policy.

Notice

Moolanomy has affiliate relationships with some companies ("advertisers") and may be compensated if consumers choose to buy or subscribe to a product or service via our links. Our content is not provided or commissioned by our advertisers. Opinions expressed here are author's alone, not those of our advertisers, and have not been reviewed, approved or otherwise endorsed by our advertisers.