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:
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
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:
|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%|
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.
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?
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®.