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.
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.