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.

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