Target Date Retirement Funds – Silver Bullet?

Target date retirement funds are fairly recent inventions created by investment brokerages to simplify the lives of investors.  Target date retirement funds take care of asset allocation for you, adjusting holdings to a more conservative mix as you near a fund’s target year, presumably a date near your retirement date.  As the fund nears the target year, stocks are exchanged for bonds or cash, effectively lessening the volatility of the fund and, as a result, helping to preserve your all-important retirement nest egg.

More and more 401(k) plans are offering target date funds due to their “set it and forget it” appeal and, accordingly, more and more individuals are choosing to place their dollars in target date retirement funds.  Although the funds have a one-size-fits-all veneer, it’s important to ask a few questions before investing in them.

Painting with a Broad Brush

Brokerages typically offer several target date funds, with a fund available for every five years from 2010 to 2055.  At first glance, it seems logical that you should choose a fund that is nearest to your retirement date.  One piece of information you should determine, though, is what holdings a given target retirement fund contains.  The Vanguard Target Retirement 2045 fund (VTIVX) holds 88.6% stock and 11.4% bonds and cash.  Fidelity’s equivalent fund, Fidelity Freedom 2045 (FFFGX), contains 73.4% stock and 26.6% bonds and cash.  An investor who is apt to take more risk would lean toward the Vanguard offering due to its almost 90% stake in stock, while a more risk averse investor would prefer Fidelity’s fund that holds close to 70% stock.  One size may not, in fact, fit all.  Additionally, holdings will change as a fund’s target date approaches and may change when a fund’s manager changes.  It’s important to take a periodic glance at fund composition to verify you are content with its holdings.

Fees, Fees, Fees

Just like asset allocation can vary from fund to fund, fees can vary, as well.  The Vanguard Target Retirement 2045 fund has an expense ratio of .19% while the Fidelity Freedom 2045 fund has an expense ratio of .76%.  While the roughly .5% difference may not seem like much, when you calculate the potential loss over the course of 30 years for a significant amount of principal, you stand to lose a good sum of money if you let expenses mount.  You have limited control over the amount of money you lose via the ups and downs of the market, but you can control which expenses you incur, so select a fund with lower expenses when choosing between similar performing funds.

Create Your Own

Due to not being content with the asset allocations in various target retirement funds, I have effectively created my own target retirement funds in my retirement brokerage accounts.  I decided on an asset allocation that I am content with (25% large cap, 25% mid cap, 25% small cap, 15% international, and 10% bonds) and chose five mutual funds in amounts that reflect this asset allocation.  As the market fluctuates, I rebalance my portfolio to maintain the desired asset allocation.  One advantage to this method of retirement investing is that I am effectively my own target retirement fund manager, can modify my asset allocation on my own timeline, can choose from many mutual funds, and don’t have to worry about a brokerage modifying my asset allocation.  A drawback to this method is that some funds have significant minimum investment requirements, so beginning investors may need to accumulate investment money for some time before investing in multiple funds.

For investors who prefer a hands-off approach, target date retirement funds are great options.  Coupled with an early start to retirement investing and regular contributions to retirement accounts, target retirement funds can help you grow a sizeable nest egg.  If you find that target retirement funds don’t exactly meet your needs, though, consider filling your portfolio with funds that match your desired asset allocation while minimizing fees.  By following either approach, you’ll be on your way to financial freedom in your retirement years.

Happy Independence Day

Happy 236th birthday to our wonderful country!  I wish you and your loved ones a happy and blessed Fourth of July.

Grow Your Retirement Portfolio with Dividends

In the past, I typically looked at four criteria to evaluate mutual funds for my retirement portfolio:

  • Asset Allocation – The asset classes (i.e., stocks, bonds, cash, etc.) I have chosen to invest in based on my timeline and risk tolerance.  Since retirement is in the distant future, I’m willing to incur more risk in seeking higher returns.  For me this means a portfolio that is heavy with stock funds.
  • Rate of Return – The higher this number is, the better.  I look at rates of return over large periods of time (five, ten, twenty year windows) since I have a long time until I retire.  Also, I compare rates of return with mutual funds in the same class (small-cap, mid-cap, international, etc.), with the goal of choosing a relatively better performing fund if I have the ability to choose from multiple funds within the same class.
  • Expense Ratio – The lower this number is, the better.  Expense ratios, measured as a percentage of your investment, track what it costs an investment organization to run a mutual fund.  If I am able to select from multiple funds within the same class and the funds have relatively similar rates of return, I choose the fund with the lowest expense ratio.  The lower the expense ratio, the more money you get to line your own, rather than somebody else’s, pockets.
  • Morningstar Rating – This rating measures how a mutual fund has performed relative to other funds in the same class.  Mutual funds are rated on a scale of five stars- this helps you to gauge whether a fund you’re selecting is a bad performer.  If a fund has one star, it’s in the bottom 10% of its class- stay away.  The next four stars chart the next best 22.5%, 35%, 22.5%, and 10% of performers.

This January, after evaluating the performance of my mutual funds, I discovered another criteria with which to evaluate mutual funds and stumbled across something that caused my balance to grow more than I expected:  dividends.  Dividends are company earnings that a given company can choose to distribute to its shareholders.  Not all companies distribute dividends, as a dividend distribution requires that companies have surplus cash.  Dividends are generally distributed once, twice, or four times a year and a company may choose to increase or decrease dividend payments, or may choose to start or stop issuing dividends according to the wishes of its leadership.  Note that dividend payments are included in a mutual fund’s rate of return, so use dividend yields as only one criteria when choosing to invest.

From December 2011 to January 2012, I noticed one of my mutual fund balances had increased by several hundred dollars, equivalent to slightly more than 3% of my previous balance.  My initial thought was:  “Wow, I wasn’t expecting this!”  I then became curious how to calculate this amount and how I might calculate future dividend payments.  Using finance.yahoo.com, I plugged in the ticker symbol associated with the mutual fund (FFFFX in this case).  I then went to the “Historical Prices” page and selected “Dividends Only” and clicked “Get Prices”. For the dividend issued on December 29, 2011, you see “0.25 Dividend”, which means I was given a dividend of 25 cents per share. To use a round number, let’s assume I started December 29 with 1,000 shares at an opening value of $7.36 per share, which translates to $7,360 total in FFFFX.  The 25 cent dividend was then multiplied by my 1,000 shares, for earnings of $250.  Rather than only experiencing an increase in share price, I acquired 33.97 additional shares, which will allow future dividend payments to grow, as future dividend payments will be calculated based on the 1,033.97  shares I hold rather than the original 1,000 shares.

A key takeaway:  Reinvest dividend payments.  This will allow for future dividend payments to multiply on top of previous dividend payments.  For long-term buy and hold investors, in addition to regular contributions, time, and compounding interest, dividends are an additional tool you can use to grow your retirement portfolio.