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Target-Date Funds: A Simple Way to Save for Retirement?

Wednesday, May 12, 2010   

Over the past five years, target-date retirement funds have surged in popularity, growing fivefold in assets and becoming an option in three out of four workplace retirement plans.  These “set it and forget it” mutual funds offer quick and easy access to a diversified portfolio that automatically adjusts as you get closer to retirement, but they aren’t without their limitations.  It takes a little bit of homework to avoid the potential pitfalls of this simplified savings solution.

Simplicity vs. Personalization

For those looking for a low-maintenance retirement savings plan, target-date funds are an easy sell.  With a small initial investment in a target-date fund, investors get an instantly-diversified portfolio without having to choose multiple funds.  As retirement approaches, the fund automatically follows a predetermined glide path, adjusting its allocation toward a more conservative asset mix and eliminating the need for rebalancing.

Of course, with simplicity comes a lack of personalization.  Everyone who plans to retire around 2035 doesn’t have the same financial and emotional capacity for risk.  An investor with a substantial guaranteed pension may be able to handle a more aggressive allocation, while someone who gets uncomfortable with a 10% drop in the market would be better off with a less aggressive portfolio.  Additionally, the breakdown of fund holdings, such as the ratio of domestic to international stocks, is set by the fund manager, so if you have strong opinions about an appropriate asset mix, you’re probably better off building your own portfolio.

Best for Young Investors

Generally speaking, the low investment minimums and one-size-fits-all nature of target-date funds make them most appealing for first-time investors.  For an initial investment of just $3,000, Vanguard’s Target Retirement 2045 Fund (VTIVX) exposes an investor to a diversified portfolio of U.S. stocks, international stocks (including emerging markets), and bonds.  To replicate the same five-fund portfolio outside of the target-date fund would require a $15,000 initial investment, not to mention the hassle of figuring out where to invest subsequent contributions.  Young investors are also less likely to have complex retirement situations or strong investing opinions that would steer them away from a one-size-fits-all solution.

Choosing a Target-Date Fund

If a target-date retirement fund seems like a good fit for you, be sure to pick a fund based on its asset allocation, not the target date.  It may sound odd, but funds with the same target date can vary significantly in their current holdings and intended glide path.  More importantly, you shouldn’t base your asset allocation solely on your time horizon until retirement.  By choosing a fund that’s consistent with both your financial and emotional tolerance for risk, you’ll be more likely to stick with your plan when market uncertainty arises.  If you need help picking a target-date fund that’s consistent with your risk profile, we can help.  Our free portfolio recommendations suggest a risk-appropriate mix of stocks and bonds that can easily be matched to a target-date fund.

Secondly, be conscious of fees and taxes.  The fund-of-funds structure employed by target-date products can contain multiple layers of expenses, so choose a fund with a low overall expense ratio and index-based investments.  You should also hold your target-date fund in a tax-sheltered account, as the automatic rebalancing feature can generate unwanted capital gains distributions.

Finally, don’t get lulled into a false sense of security by owning a fund that matches your anticipated retirement date.  It should go without saying, but all investments involve risk, and as many target-date investors discovered in 2008, a sizable investment in a target-date retirement fund doesn’t ensure a healthy retirement. 

The chart below compares a few popular funds with a target retirement date of 2035, as reported by Morningstar.

Target-Date Retirement FundExp. RatioUS StocksInt'l StocksBonds/Cash
Fidelity Freedom 2035 Fund (FFTHX)0.78%59%21%20%
T. Rowe Price Retirement 2035 (TRRJX)0.79%67%21%12%
Vanguard Target Retirement 2035 Fund (VTTHX)0.20%71%18%11%
Posted by George | DIY Investing | Comments (0)
 

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