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 preferring to manually manage my own 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?
First let’s start with a brief definition of Target Retirement Funds. A target retirement fund is a mutual fund designed with a specific retirement year in mind (usually in 5 years increment). 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 — i.e., investing in more fixed-income investments — to decrease risk and preserve capital.
For example, here’s Vanguard 2010 versus 2040 to give you and idea on how the fund changes over time:
Vanguard Target Retirement 2010 (VTENX)
Vanguard Target Retirement 2040 (VFORX)
Roughly speaking, Vanguard 2010 is more conservative with 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 money sitting in your 401k and not invested.
- 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
However, 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 where 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; and, owing fixed-income investments would do the opposite.
- Hard To Evaluate — Because Target Retirement Funds are relatively new, they don’t have long-term track record. Secondly, it’s hard to compare them to an index like the S&P500 because they are diversified — i.e., has both equity and fixed-income investments. Third, it’s hard to compare Target Retirement Funds from different companies — i.e., Vanguard, Fidelity, etc. — 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 financial goals or risk tolerance level into account. However, you could personalize this a bit. For example, if you have higher risk tolerance or need to invest more aggressively to reach your goals, you could buy a higher dated fund — i.e., buy 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 existing portfolio, or at least, be very careful with its asset allocation. This could be a problem for investors with large existing portfolio due to trading costs and potential tax consequences (i.e., especially for investments in taxable accounts).
Actively Managed Fund
Secondly, some Target Retirement Funds are actively managed and there’s a 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 Fund which is made up of index funds.
Conclusion
Personally, I am still undecided whether I should leverage a Target Retirement Fund or not. 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 — this will certainly make life more simple. Also, I think Target Retirement Funds are good for people who don’t want to bother managing the portfolio on their own; and this is far better than neglecting the portfolios altogether.
What’s your thought on Target Retirement Funds? Do you invest in them? What do you like or dislike about them?
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@ 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.
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.
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.
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.
“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.
@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.
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).
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.
@MITBeta — That’s a very good point about TRF. Thank you for adding that.
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?
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.
@WisdomBread – Yes, it was confusing to me too and that why I was corrected by my readers.
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.....penses.asp 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.”