You open your 401(k) packet, to find a targeted retirement fund, among the selection of mutual funds. Amazingly, this fund with a target date of 2050, matches perfectly with your investment horizon. You go to the fund’s website to find this target fund advertises itself like one stop shop for investing. The way the mutual fund company puts it, you don’t have to do a thing once you’ve made your selection. You can get back to work and let the magic of compound interest work in your 401(k).
But can investing really be that easy? Can you just login to your 401(k) or IRA account, select the target date fund, and call it a day?
The purpose of this post is to take an in depth look at target retirement funds. Looking closely at the advantages, disadvantages, the disparity between funds, and finally, tips for investing in targeted retirement funds.
What is a Target Retirement Fund?
A target date retirement fund, also known as life cycle fund, offers investors a mutual fund allocated towards a specific retirement date. For example, if you invested in such a fund with a target retirement date of 2050, the fund will invest in specific asset classes that matches that time horizon.
Advantages of Targeted Retirement Funds
- Instant diversification, matched to retirement date.
- No need to rebalance or readjust asset allocaton, as you get older. The fund does so itself.
- You can get by with owning just one fund, since most target date retirement funds offer exposure to each asset class.
Disadvantages to Targeted Retirement Funds
- Targeted retirement funds base their asset allocation on years until retirement, not your individual risk.
- Even though most target retirement funds are made up of low index funds, some fund companies and 401(k) providers, charge a high fee to invest in their target funds.
- There is no standard or regulations on asset allocation for target retirement funds. Therefore, asset allocation changes dramatically from one fund to the next, even if they have the same target date. In late 2009, Morningstar reported that the range of stock allocation in 2010 target funds, ranged from 26% to 65%.
- Changes can be made to the fund’s core strategy by fund manager. For example, in 2009 Fidelity added TIPS (Treasury Inflation Protected Securities) to the Fidelity Freedom 2050.
- Many investors hold a targeted retirement fund, along with other mutual funds. Thus, their asset allocation varies from the recommended allocation of the TDRF.
A Comparison of 4 Different Target Date Retirement Funds
Below is a comparison of four different target date retirement funds. The point here is not to pick out which targeted retirement fund is the best. The purpose was for you to see how a fund with a target date of 2050, can change dramatically from company to company.
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Here is what stands out to me:
- International stock allocation ranged from 16.70% to 32.94%
- Bond allocations ranged from 1.33% to 15.8%
- Cash ranged from 0 to 2.4%.
- Expense ratios range from .19% to .91%. (Keep in mind that if these funds are in your 401(k)s, these fees can change dramatically)
To add more complexity to the issue, the diversification, the investing within the asset classes themselves, also varied drastically from fund to fund. For example, for Vanguard’s U.S. stock allocation, they diversify by holding the Vanguard Total Stock Market Index Fund. In comparison, Fidelity includes the following funds for in their U.S. stock fund holdings:
- Fidelity Series All-Sector Equity Fund
- Fidelity Series Large Cap Value Fund
- Fidelity Disciplined Equity Fund
- Fidelity Growth Company Fund
- Fidelity Series 100 Index Fund
- Fidelity Blue Chip Growth Fund
- Fidelity Series Small Cap Opportunities Fund
- Fidelity Small Cap Value Fund
- Fidelity Small Cap Growth Fund
- Fidelity Series Commodity Strategy Fund
Set It and Forget It?
Although target date funds are marketed as a set it and forget it approach to investing, they’re anything but.
First, you have to do your homework to make sure your targeted retirement fund matches your risk profile.
And once you start investing in a target date fund, the homework doesn’t stop. It’s wise to keep up with any core changes to the fund such as expense ratios, overall strategy, asset allocation, etc… By reading the prospectus once a year.
While this requires less work from doing the rebalancing, asset allocation, etc…yourself, it’s by no means a set it and forget it approach.
Tips for Investing in Target Retirement Funds
I myself, own a targeted retirement fund in my Roth IRA. Specifically, Vanguard’s Target Retirement Fund 2050.
The fund works for me because it’s the equivalent to how my portfolio would look, even if target funds didn’t exist.
If you decide to invest in a targeted date retirement funds, here are a few tips to making sure your fund of choice, is a good one:
- Don’t look at past returns. The histories of targeted retirement funds are short.
- Know the expense ratios. Keep it as low as possible.
- Read its prospectus. Find out how the allocation changes as you get closer to retirement. Know what happens to the fund after you reach its target date.
- Know your risk tolerance. If you can’t stomach any losses, you might be better off investing in fund with a closer retirement date.
In the comments, I would love to hear from people who have invested in targeted retirement funds, and why? Or, for those of you who haven’t invested in a target fund, why?
{ 13 comments… read them below or add one }
I think Target Retirement Funds are really good for those new to investing and don’t want to have to manage their portfolio. However, I agree with you that there is no real standard to these target funds and it makes it very difficult to compare and benchmark the returns.
Personally, I would stick with a target fund with a low expense ratio. 0.91% is way too high of an expense for me to stomach.
Dave – Along with sticking to low expense ratio, I would add that make sure to invest in a TDR that matches your risk.
Along with beginners, I also think TDR’s are good for experienced investors. As I said, I myself invest in a TDR.
My 403(b) through my company is the Fidelity TDR. You could pick your target date, but that was pretty much the only choice you have. I think my company did it this way because they’ve had many people in the past not contribute, and when they retired ended up with very little. So now, there is a guaranteed amount given by the company for retirement, but you have to invest with Fidelity.
That’s similar to other 403(b)s. Just wondering, can you only invest in TDR funds, or do they have other options as well?
The other thing to consider with Target Date Funds is the Expense Ratio. This can eat into returns over time. But there are some good target date funds out there with low expenses and no sales load.
Of course. If I didn’t make that clear enough, that’s my fault. Finding a TDR with a low expense ratio is a must.
That’s what Vanguard is for!
I think they can be useful, but are not really that great for someone willing to put in some effort. The most important thing to do is save. The next is to diversify and manage risk. The next is to find low expense options.
While targeted funds are easy and that can be a good thing, failing to understand investing a bit is very risky. It is nice that I happen to like investing. But even if I didn’t I realize the payoff for learning a bit about investing is huge. Taking the easy way out might not be the best idea. I would be much more comfortable with someone who did learn and continue learning but still decided to use a targeted fund than with someone that just picked it out at 25 and didn’t think again about it until 55.
You bring up a great point. Sometimes people think of investing in targeted date retirement funds as n excuse not to learn anything.
My money is currently in Vanguard’s STAR fund, but very soon I’m making the switch to a TDR fund: I’m looking for a much more aggressive allocation. While I educate myself on investment strategies and financial knowledge, I do like the concept of a TDR fund. The rest of my knowledge may come in handy when I have extra money to experiment with (not a luxury familiar to a grad student).
Sounds like your on the right path Eric. The STAR fund to TDR fund is a great approach for someone wanting to invest with Vanguard, but can’t meet the minimums as of now.
Not only does Fidelity charge 0.84% management fee for the targeted fund, I bet you are also paying a management fee to all of those actively managed funds that make up 66% of the portfolio. When you compare that to the low fees on Vanguard’s index fund, the amount of your money eaten up in fees is outrageous. My problem with TDR funds is you double your expenses by having two layers of funds when you can diversify yourself for free. Just copy these approximate ratios in index funds and save yourself the TDR management fee.
It really depends on the mutual fund company you work with, but I know that Vanguard, doesn’t double up their expenses. Therefore, their .19% ratio is not a fee for investing in a TDR, rather the total expense ratio.