My company made Vanguard Target Retirement Funds available for our 401(k) accounts about two years ago. I have been evaluating these options, however, I have not moved my money into one of these funds yet because I prefer to manage my own asset allocation using the more traditional asset class-based funds. However, I think Target Date Fund is an excellent option for 401(k) plans in general because it is a less intimidating way to present investment options to participants and will probably encourage a higher investment rate overall.
What are Target Date Funds?
A target date fund, or target retirement fund, is a mutual fund designed with a specific retirement year in mind. For example, if you are 20 years from retirement, and this is 2019, you’d pick a fund with a target year of 2019 + 20 = 2039. Since they are usually offered in 5 years increment, a 2040 Target Retirement Fund is the option you’d consider.
As the fund approaches the target retirement year, the fund asset allocation becomes more conservative — investing in more fixed-income investments — to decrease risks and preserve capital.
Here’s Vanguard 2010 versus 2040 (data as of Dec 2008 when this was originally written). This comparison illustrates how the fund changes over time:
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.
Target Date Funds Advantages (Pros)
Personally, I think there are two things that make Target Retirement Funds attractive.
1. Easy to Understand and Start
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 401(k), you’ll automatically add to your position without having to worry about asset allocation and regularly rebalancing your portfolio. This is perfect for people who are afraid to get started with investing.
2. Instant 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 (data as of Dec 2008):
|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%|
3. Less Expensive for Businesses
This benefit might not be obvious to individual investors, but as a business owner, I had the opportunity to set up a Solo 401(k) account with Vanguard. One of the things I have to decide on was what investments I would like to have available in the plan. The only problem was that it would cost $20 per year for each Vanguard fund held in the 401(k) account. To save money on administrative fees, I opted to have only one fund…you guessed it…a Target Retirement Fund. (updated 2019)
Target Date Funds Disadvantages (Cons)
There are also a few things that make Target Retirement Funds unattractive:
1. 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.
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.
3. Hard To Evaluate
Because of the two layers structure, they are harder to evaluate than a traditional fund. 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.
4. Same Date, Different Allocation
You might have a false sense of security that just because the fund is targeted for a certain date that you’re getting the most optimized for that retirement date. Here is an excellent example using two of the most popular target date funds:
- Vanguard Target Retirement 2040 Fund’s Objective: Seeks to provide capital appreciation and current income consistent with its current asset allocation. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund.
- Fidelity Freedom® 2040 Fund’s Objective – Seeks high total return until its target retirement date. Thereafter, the fund’s objective will be to seek high current income and, as a secondary objective, capital appreciation.
So they both have fairly similar objective, now let’s see what an optimized asset allocation for 2040 looks like (data as of July 2019):
That’s a huge difference!
In summary, it is 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.
5. One Size Fits All
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. Another option is to add more traditional investments in the area(s) that you want to increase your exposure to.
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.
1. 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.
2. 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.
Personally, I remain undecided about whether or not I should leverage a Target Retirement Fund in my 401(k) account. I enjoy managing my own portfolio, and there are some disadvantages to consider. However, 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?
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.