Retirement Target Date Funds are rapidly surging in popularity lately. Investors are flocking to this “set it and forget it” retirement tool as an easy way to diversify their portfolio and eliminate the fees of working with a high cost broker.
Just as the name describes, the funds are designed around your target retirement date. For example, if you're thinking you will reach the retirement promised land by 2045, you would invest in a fund like the Vanguard Target Retirement 2045 Fund (VTIVX). As you can see from the VTIVX chart below, your equity holdings will decrease as you get closer to retirement while your fixed income holdings increase. This way you're decreasing your risk and volatility as you get closer to your target retirement date.
Honestly, these funds sound like magical retirement options that have little to no downside. But there's always two sides to every coin. Let's take a look at the pros and cons of Target Date Funds.
Pros of Retirement Target Date Funds
1. Automatically Adjusts Holdings
As you approach your retirement date, the equity and fixed income allocations adjust according to the current date. Let's use a fictitious character named “Andy Hill” as an example:
- Andy is 35 and he plans to retire in 2045.
- Right now, his allocation is around 90% equity (stocks) and 10% fixed income (bonds).
- When Andy turns 55, his holdings will adjust to approximately 75% equity and 25% fixed income.
- The Target Date Fund automatically decreases your risk as you draw closer to retirement.
- Set it and forget it as they say …
2. Rebalances on your Behalf
An important action that every investor needs to take is rebalancing your portfolio. A bull market for stocks, like we've seen over the past 8 years, can increase your equity percentage and drive down your fixed income percentage. To maintain your original investment strategy, you'd need to rebalance your portfolio by selling off some equity holdings and purchasing more fixed income holdings.
With Target Date Funds, this action is already taken care of. The funds will rebalance themselves so you don't have to worry about your correct asset allocation.
— Andy Hill (@AndyHillMKM) February 13, 2017
3. Invests in Index Funds
Target Date Funds, through a company like Vanguard, invest in index funds. Index funds give you the advantage of investing in the “Total Stock Market” or the “Total Bond Market” in a low cost and efficient way. Let's continue using VTIVX as an example below:
Allocation to underlying funds as of 02/28/2017
|1||Vanguard Total Stock Market Index Fund Investor Shares||54.2%|
|2||Vanguard Total International Stock Index Fund Investor Shares||35.8%|
|3||Vanguard Total Bond Market II Index Fund Investor Shares||7.1%|
|4||Vanguard Total International Bond Index Fund Investor Shares||2.9%|
- There are four index funds that make up VTIVX (US Stocks, International Stocks, US Bonds, International Bonds). You're getting a 90% equity and a 10% fixed income allocation and further diversifying by not holding all of your investments in the United States. And since these are index funds, you're diversifying even further by spreading your investments across thousands of companies.
4. Low Cost
Since Target Date funds (like VTIVX) invest in index funds, they inherently cost the investor very little compared to working with a broker or purchasing non-index mutual funds.
As a basis for comparison, the expense ratio for VTIVX is currently 0.16%. If you work with a typical broker, you may pay 1% for their fees in addition to a 1% expense ratio of the mutual funds they are recommending to try to beat the market. The difference is 1.84%. That might not sound like a lot of percentage points, but over time it can truly eat up your overall returns and make retirement difficult to reach.
Cons of Retirement Target Date Funds
1. No control
If you're into having control of your overall portfolio and actively managing your equity and fixed income holdings, Target Date Funds are not for you. Some people enjoy the “set it and forget it” model, but others who are more active in their investing want to steer the ship per se.
2. Expense Ratios Could Be Lower If You Invest More
Although Target Date funds have super low expense ratios, you could get an even lower expense ratio if you invest in the underlying index funds.
Let's go back to VTIVX to explain. One of the index funds that makes up VTIVX is called “Vanguard Total Stock Market Index Fund Investor Shares” (VTSMX). If you choose the “Admiral Shares” version of this index fund (VTSAX) which has the same investment make up as the “Investor Shares” version but requires a $10,000 minimum, you'd only pay 0.05% for the expense ratio instead of 0.16%.
Again, this is a small additional percentage to pay, but it can truly add up over time.
3. Too Much Bond Investment
Some folks I've spoken to feel that Target Date Funds are too heavily weighted toward bonds overall. They would prefer more of their investments to go into stocks to take advantage of the higher returns especially during their younger years.
To each his own!
My Take on Retirement Target Date Funds
In short, if you want to “set it and forget it “, go with target date funds. The hands off nature, broad market diversification and low costs make Target Date Funds extremely attractive. Much better than working with a high cost broker!
If you want to have a little more ownership, responsibility and get a lower expense ratio because of it, create and manage your own portfolio. You can even mirror the index fund investments in your favorite Target Date Fund if you don't mind the bond investments involved. Just be sure to rebalance your portfolio at least once per year to ensure you're not out of whack.
Since I fall into the money nerd category where I don't mind a bit more responsibility, I'll probably keep consistent with my non-Target Date Fund approach toward my Roth IRA investing and 401k investing.
Who knows? When you're managing your own retirement portfolio, you always have the option to always change your mind.