3 Tips for Target Date Fund Investors

bulls eye photoTarget date funds have become very popular as a simple way to save for your retirement. You pick the target date fund with the date closest to when you plan to retire (e.g., 2025, 2040, etc.).  The fund gradually increases the proportion of bonds compared to stocks as the target date approaches.  Asset allocation – the proportion of stocks and bonds in a portfolio – is the single largest determinant of a fund’s returns.

There is no agreement or standards among target date fund suppliers, however, about the path to a more conservative asset allocation, where it ends, and the asset allocation after reaching the target date.

Ask these three questions if you are considering a target date fund, either in your 401k plan or in an Individual Retirement Account (IRA), to see if they are right for you.

They may not be. There also may be a less expensive way to build your own portfolio using three broad-based, low-cost index funds that mirrors a target date fund strategy but that better matches your investment/retirement needs.

1. How does the Target Date Fund Fit into your Retirement Income Strategy?

Target date funds are designed to be your sole or substantial source of retirement income. They use an asset allocation that gets more conservative as the target date approaches. The idea is to minimize your risk as you enter retirement so that you have a secure source of retirement income.

These funds may move too soon to a bond heavy allocation that may be inappropriate if you have other sources of retirement income (Social Security, a pension, rental income, part-time work, other taxable savings, etc.). These funds may not be necessary for a secure retirement because you have other assets on which to rely. Thus, you could be leaving potential gain on the table because the fund moved too quickly into a conservative asset allocation.

So consider how the target date fund fits into your retirement plan. It may be appropriate if it is the main source of your retirement income, otherwise, it may leave potential gain on the table.

2. How does the Target Date Fund Operate?

Target date funds use different approaches to execute their strategy. They follow the same general approach to move to a more conservative asset allocation over time but they do so in different ways. The 2040 target date funds from Fidelity (FFFFX), T Rowe Price (TRRDX), and Vanguard (VFORX) illustrate differences among four key attributes.

  • Asset allocation now:  Currently both Fidelity’s and T Rowe Price’s funds have 90% in stock mutual funds (the remainder in bond funds). Vanguard’s fund has a slightly less aggressive stock allocation now.
  • Target Date Allocation:  By 2040, Fidelity’s fund will have 60% in stocks, T Rowe Price’s fund will have 55% in stocks, and Vanguard’s fund will have 50% in stocks.
  • Post Target Date Allocation:  Fidelity’s fund keeps growing more conservative so that by 10-19 years after the target date (2050-2059) it will have a 25% stock allocation.  T Rowe Price’s fund will have 20% stocks 30 years after the target date (2070). Vanguard’s fund will achieve its final allocation of 30% stocks within seven years after the target date (2047).
  • Mix of Investments:  Each of the three funds use their own in-house funds to make up the target date fund. Fidelity and T Rowe Price use a mix of actively managed funds, whereas Vanguard uses a mix of its index funds.

As you can see there is substantial variation among similar 2040 target date funds. My advice is to understand how your fund works to see if it matches your preferences.

3. What are the Target Date Fund’s Expenses?

Fees, fees, fees.  They have such an impact on your overall return. Vanguard 2040 fund’s fees are the lowest among the three 2040 Target Date Funds at 0.16%. The Fidelity and T Rowe Price funds have fees of 0.75%. These fees are already deducted from the fund’s return. It is in your interest to use mutual funds with low fees to maximize your return.

An Alternative to Target Date Funds

An alternative to a target date fund is to simulate one using three basic building block funds:  a total domestic bond fund, a total domestic stock fund, and a total international stock fund.  Fidelity, Schwab, T Rowe Price, and Vanguard offer these three low-cost funds. The idea is to use these three funds that cover nearly the entire stock and bond markets at minimal cost in an asset allocation that matches your preferences. This blog entry discusses how to decide the asset allocation that is right for you.

In sum, target date funds may be right for you if you know how they work and they provide a substantial part of your retirement income strategy. Target date funds may be inappropriate if you have varied sources of income and have the ability and/or desire to create your own balanced portfolio with an appropriate allocation of low-cost index funds.

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