Let’s face it — many of us are not comfortable with investing in the stock market. This is especially true for young folks who just started their first job and are still trying to pay down their student loans. To make it easier for new investors, the financial institutions came up with “target date funds.” These funds make retirement investing very simple because you just have to pick your retirement date and keep investing into that fund.
How do Target Date Funds work?
The main idea behind these funds is that they will adjust your investment asset allocation as you age. When you are young, the majority of the portfolio will be invested in the stock market. As you get older, the fund will shift more and more money to safer investments (usually bonds).
Let’s look at Vanguard’s Target Date Funds
*This table was made on February 2013.
As you can see, the fund gets more conservative as you approach the target retirement date. You’ll need more stability as you near retirement, so the fund will shift more assets toward bonds.
Vanguard’s 2040 Target Date Fund – VFORX
The 2040 Target Date fund is designed for investors planning to retire between 2038 and 2042. That’s right in the range of my full retirement target. Here is a more detailed look at VFORX.
One important thing to note is that the target date funds usually invest in their own family of funds. If the underlying funds aren’t any good, then the target date fund will reflect that. VFORX is quite simple. It just has 3 underlying low cost index funds. I did a little math and it looks like you’ll pay the same expense ratio if you try to duplicate VFORX with the same underlying funds. I like Vanguard because their expense ratio is very low compared to other funds. It is also nice to have some exposure to international stocks when you invest in VFORX.
Should you invest in Target Date Funds?
The target date fund is great for new investors who are having a difficult time picking the right fund in their 401k plan. The most important thing when you are starting out is to simply start investing as soon as possible. The choice of investment won’t make a big difference until your portfolio is more substantial. For new investors, I would recommend just plowing money into either a total market index fund or a target date fund. Once a new investor learns more about stock market investing, he can reallocate the investment elsewhere.
Check these before investing in Target Date Funds
Fees
Target date funds can have higher fees. Putnam RetirementReady 2040 A (PRRZX) for example, has a gross expense ratio of 1.32%. This is more than 7 times as much as the Vanguard funds and it will zap your return.
Compare long term performance
One way to quickly check your target date fund is to compare it to VFORX on Yahoo! Finance. Just follow the link, then click on COMPARE and enter your target date fund symbol. This will give you a comparison over the last 5 years. Your target date fund should be comparable to VFORX. If it’s much worse, then perhaps it might be better to go with another fund in your 401k.
See if the asset allocation ratio makes sense for you
You need to check the asset allocation to see if you are comfortable with it. Let’s look at the Vanguard 2040 Target Date fund again. The bond allocation is only 10% of the portfolio. Most folks who choose the 2040 Target Date fund are close to 40 and may not be able to tolerate such a low bond allocation. One old rule of thumb is to use your age as the percent to own bonds and invest the rest in stocks. With this old rule of thumb, an investor should have 40% in bonds. This is up to you, though. I have a high risk tolerance and don’t mind the volatility because I still have over 25 years left until full retirement. 10% in bonds is fine with me.
Read the prospectus at least once a year
You should check the prospectus at least once a year to see the asset allocation ratio. You might be comfortable with the asset allocation now, but the manager might change their strategy suddenly. In the past, we have seen Vanguard reduce the percentage of bonds and they may do so again. You just need to check on it once a year to make sure your fund is still doing what you expected.
Target Date Funds simplify investing
All in all, I like the target date fund. It makes investing very simple and encourage more workers to save. Mrs. RB40 has been investing in the 2040 Target Date fund in her 401k plan for many years and it is paying off for her. Her fund is very low cost and its performance is in line with VFORX. She kept investing through the downturn and her 401k is doing very well. She doesn’t have to worry about rebalancing and she likes it that way.
Target date funds can be a good investment for investors who are in the accumulation phase. Once an investor approach retirement and have more assets, then a better option would be working with a financial adviser to come up with a personalize plan.
Disclosure: I am not a financial adviser. I am writing from my experience and research. You might want to talk to a financial adviser before making a big move in your investment portfolio. Sign up with Personal Capital and you can get a free financial analysis and it can be a good first step.
Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!
Joe also highly recommends Personal Capital for DIY investors. They have many useful tools that will help you reach financial independence.
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Well, I have the VFORX and that is good enough for me. I contribute the maximum amount to my Roth each year and want my investments to be automatic. I don’t like stressing out about investing. I’ll gladly take peace + calm = decent returns over fear + anxiety = spectacular returns.
Nice article as you hit on many of the issues/topics we discuss when doing our live education meetings. For individuals new to the work force ( 21-25 y/o), they are a great start to putting money away. Once you get a better understanding of investing and retirement planning, we would suggest that you setup your portfolio with index funds that capture the broad market segments needed for a diversified portfolio. The problem is many people are too lazy or the fact that retirement is so far away usually gets in the way of staying on top of their asset allocations.
– Mark
I’m indeed a new guy in the work force. I was going to put my money in a Vanguard Target Retirement Fund, which charges 0.18% for expenses. Don’t these funds consist of stock index funds that capture the entire stock market? It seems that you imply that these funds don’t capture the whole stock market.
I’ve never been a fan of Target Date funds. I just don’t really like the “one size fits all” approach. They might be a good option for people who really don’t have an interest in managing their investments, but I think anyone with the slightest interest would be better served to come up with their own mix of investments.
I have an RRSP mutual fund at my bank and I just had a sit down in the office with my bank lady. I am about to turn 49 and she wanted me to move in to a lower risk fund because I have entered in to a new age category. Most depressing 20 minutes I have ever spent in a bank.
Sorry to hear that! Did you try personal capital? It might be worth getting a second opinion. The financial planner at the bank are usually not that great.
I’ve looked into target funds and it might be something I want to invest in with the next year. I really don’t know what I’m doing, so this might be the easiest option for me to begin with. I personally like the USAA target funds, they have low fees.
Is that in your 401k plan? 0.8% is still a bit high for me.
I like Target Date funds and actually use the Vanguard target date funds in my retirement portfolio 🙂 It is a great way to invest as long as it meets my objectives and risk profile which I watch closely.
Another win for TDF! 🙂
I never liked target date funds! I prefer changing the allocation myself. I think they are appropriate for people who do not want to monitor ther investments.
I do a target date fund, but that’s mostly because I am not quite sure what I’m doing, and I know that putting money into my IRA is a good thing to do — it might not be optimal, but at least the money is getting there!
What fund do you have? What’s the expense ratio?
It’s nice to hear that Vanguard has some low cost target date fund options. I remember when these first came out, the expenses were ridiculous…much like that Putnam fund you mention.
I think they are great for people who are overwhelmed with trying to build a diversified portfolio. Personally, I enjoy managing multiple funds myself, but see the benefit in target date funds for others.
I guess most bloggers are the self managed type. 🙂
Sorry to come across a bit cynical, but like everything else done on Wall Street and by “professional” money managers, I think target funds are 100% about marketing and 0% about providing tools to help investors reach their retirement goals. The impetus behind them is to corral more $$ and earn more management fees, period. I think target funds’ targets are not a retirement year, but rather those individuals who don’t have the time or interest to research investing and manage their money proactively. The best approach is self-education and self-management. There are plenty of resources around (like RB40 for example!). But if you lack the time or just can’t make yourself do that, hiring a financial planner may be a better Plan B than target fund investing.
Unfortunately, many people aren’t educating themselves about investing. I think working with a financial planner is a good idea too.
Just because there is an incentive for the managers doesn’t mean it’s a bad investment. Like any fund, TDFs are symbiotic in nature. With the Vanguard funds, however, the fees are very, very low (currently .18 for the TDF 2045). One strategy I am trying is to allocate among target date funds AND non-TDFs. So, I’m early thirties, and 70% of my 401(k) portfolio is in a TD 2045. The other 30% is in three different funds that replicate the 90/10 split of my TDF but are invested in different classes of equity than what’s in my TDF. This way, I can avoid the lack of diversification inherent in the equity CLASSES in my TDF. Working pretty well so far. If I stick with it, I’ll have to rebalance myself for the 30% of my portfoli that’s NOT in a TDF. I think this is a good exercise for somewhat lazy/passive investors – keep most of the money in a TDF and see how vigilant you are in monitoring and, where appropriate, periodically reallocating a minority percentage of your own portfolio.
That’s a good idea. It’s good to have some diversification with small cap and other classes.
Nice post and an excellent job of explaining how TDFs work. I am generally a fan of these for younger investors, but once someone gets to say 45ish they really shouldn’t be in a TDF in my opinion. As an example my 24 year old daughter is in a long-dated fund (I think 2055) which is fine for here as a retirement plan choice. TDFs are a staple in 401(k) plans and this is where many folks are faced with the choice of going this route or allocating their account from among the funds offered. I really encourage most folks to go the latter route. In any event if one does choose to invest in a TDF it is key to understand how the fund will invest your money and the fees and expenses (as you pointed out). This is not a set it and forget investment, in fact there are no such investments that I am aware of.
Thanks for your input. 45-50 sounds about right to me as well. At that point, they’ll have to figure it out for themselves or work with a financial planner.
I think target date funds are totally acceptable. They follow the Pareto Principle – 80% of the benefit for 20% of the effort. The only thing you really have to do is make sure that you pick one that has a low expense ratio. But you’d have to do that three (or more) times if you were replicating the portfolio on your own. Don’t get me wrong, there are certainly some drawbacks and compromises. But there are also some pretty good benefits, such as automatic rebalancing.
Automatic rebalacing is the biggest benefit. That free up the investors to just concentrate on adding more money. 🙂
I don’t have any target date fund in my 401K, I have some funds (20% or so) in my Roth IRA portfolio that is in a Fidelity target date fund. I think target date fund is good for young people who like to invest but don’t know much about investment. I guess my concern for myself is that I am too heavily invested in stocks (small caps, mid caps, REITs, International and overseas) but not enough in bonds. However consider I am 33 I have a hard time get excited in putting my money in bonds.
I’ll be 40 this year and I still have a hard time getting exited with bonds. Once the rate goes up a bit, I’ll add more money to bonds. It’s hard right now with low rates.
I haven’t invested in target date funds because I want to choose my own funds and asset allocations.
When I first started saving for retirement I did it in a target date fund, which we’re still in. I liked that it gave me (some) right answers with ease. We are with Vanguard so the expense ratio is quite low. However, I have been thinking recently that I might buy the underlying index funds directly and do the rebalancing myself now that I know a bit more about it all.
I think the cost is about the same. The problem with managing yourself is that many people don’t do it. 🙂 I think you’ll do fine though.
I typically avoid target date funds. They typically charge a fairly high administrative fee (usually over 1% which is my cutoff in terms of too expensive at any cost) and all they’re doing is bundling other funds to give you an asset allocation that matches with your age. You can typically pick out your other available funds to create this allocation, with those funds usually having administrative costs much lower. A bit of DIY can save you big time compared to the ‘convenience’ that the target date funds are more than happy to charge you for.
Mrs. RB40’s target date fund has a pretty low fee. There are not a lot of options in her plan and the target date fund is a good option for her.
I’d rather just invest in the stocks directly. It might be a good fund to invest in, but it seems to risky overall to do. I feel you might be better off investing when you’ve done the proper research.
I’m not a fan of Target Date Funds. It’s so hard to predict the right allocation for your needs, and those funds have a lot of “secrets” that are hard to keep up with.
I agree with your advice that you should read the prospectus, but it can be tough for the type of investor who would opt for a target date fund instead of selecting other mutual funds or ETFs.
Here’s my article on The Trouble with Target Date Funds: http://thecollegeinvestor.com/1275/the-trouble-with-target-date-funds/
I agree, everyone’s situation is different and therefore requires specific methodical planning. Additionally anything that has a blanket solution I always approach with severe caution.