Hugh F. Wynn
Hands Free: Target-Date Funds Adjust Focus as Retirement Nears
In my humble opinion, target-date funds (TDFs) have been one of the more positive developments for retirement accounts since John Bogle exposed index fund investing to the world and millions of small investors. Let's explore why these set-it-and-forget-it funds are stars on the savings and retirement investing scene. Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
TDFs are available to investors that desire to grow assets over a specified period of time, usually for retirement. Often named for the year in which an investor plans to retire (target-date 2030 fund, for example), the fund’s asset allocation becomes a function of the time available to meet the investment objective.
TDFs take asset allocation and investment selection out of investors’ hands, and they provide a bit of inexpensive investment advice for folks who might otherwise not find such advice easily available or affordable. And who, in the absence of good information, might otherwise make unwise and/or uninformed decisions.
In addition, history shows that TDFs deliver positive outcomes.
Simple & Diverse
The notion behind TDFs is also something that has a great deal of appeal to me – simplicity and diversity. Generally speaking, most of us accept the idea that stocks are riskier than bonds; that as we grow older, it makes sense to reduce market risk by holding more bonds in our investment portfolio than stock; and that rebalancing a portfolio to properly adjust the stock/bond ratio simply makes sense along the way. Therein lies the appeal of TDFs. By design they fine-tune to a less risky (more conservative) investment mix as the so-called “target date” of an investor’s retirement looms.
This simplicity makes TDFs increasingly popular vehicles for 401(k) plans – and attractive to investors (like me) who like to put their investing activities on autopilot. Particularly when the fund’s portfolio is allocated to various index funds. Take the case of a young investor hoping to retire in 2065. He would likely choose a more aggressive target-date 2065 fund. An older chap nearing retirement (say in 2025) might choose a more conservative target-date 2025 fund.
My fund company of choice, the low-cost Vanguard, offers a comprehensive series of target-date funds. Vanguard Target Retirement Funds offer a diversified portfolio within a single fund that adjusts its underlying asset mix over time. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund (Source: Vanguard).
Let’s compare a couple of their funds to illustrate those target-date characteristics:
Vanguard Target Retirement 2065 Fund (VLXVX): The Vanguard Target Retirement 2065 Fund (formed 7/12/2017) has a low-cost annual operating expense ratio of 0.08%. The Fund’s portfolio percentage allocation (as of November 22, 2022), stood at 54.3% of assets invested in VG: Total Stock Market Index Fund Institutional Plus Shares; 36.1% in VG: Total International Stock Index Fund Investor Shares; 6.6% in VG: Total Bond Market II Index Fund; and 3% in VG: Total International Bond Index Fund. In short, there's a more aggressive 90.4% in equities and a conservative 9.6% in bonds and cash equivalents because of its long-term horizon.
Vanguard Target Retirement 2025 Fund (VTTVX): The Vanguard Target Retirement 2025 Fund (10/27/2003) has the same low expense ratio of 0.08%. The fund’s portfolio percentage allocation (as of November 22, 2022), stood at 34.2% invested in VG: Total Stock Market Index Fund Institutional Plus Shares; 21.7% in VG: Total International Stock Index Fund Investor Shares; 28% in VG: Total Bond Market II Index Fund; 12.6% in VG: Total International Bond Index Fund; and 3.5% in VG: Short-Term Inflation-Protected Securities Index Fund Admiral Shares. This fund has a less volatile, shorter-term mixture of 55.9% in equities and a more conservative 44.1% in bonds and cash equivalents.
Vanguard Target Retirement Income Fund (VTINX): Beyond the target date – for folks already in retirement or who are of retirement age – the Vanguard Target Retirement Income Fund (VTINX), which also has a low annual expense ratio of 0.08%, gravitates to an even more conservative, less volatile asset allocation of roughly 18.1% in domestic equities, 12% in international equities, 36.8% in domestic bonds, 16.3% in international bonds, and approximately 16.8% in short-term TIPS (Treasury Inflation Protected Securities).
Although I used Vanguard funds in my hypothetical example, a wide variety of marketplace target-date options are available to investors – funds with various asset allocation strategies to fit differing risk and management preferences.
Nothing is Perfect
With all the talk of their conservative mix of highly diversified investments as retirement nears, TDFs are not without limitations. The Great Recession of 2008-09 reminded many investors - even those close to retirement - of TDF shortcomings. They still hold a certain percentage of investments in riskier stock, and they take a one-size-fits-all approach to investing. In short, the funds simply can’t consider each individual investor’s unique portfolio needs. And the automatic approach to investing strategy ignores changing market conditions. Therefore, it’s important that investors consider the caveats of their risk profile when considering TDFs, including the cost and performance of a particular company’s TDF portfolio.
Also, it’s always…always…essential to compare fees, and it goes without saying that any conscientious investor should continue to pay attention to changing market conditions.
Manage Your Expectations
For inexperienced investors dealing with an array of confusing choices offered by their employer’s 401(k) program, TDFs can be a relatively low-risk starting point in the saving and investment cycle. But, keep in mind that conditions change in an investor’s financial life, so the types of investments suitable to those shifting circumstances might also change. A TDF fund could very well end up being too conservative, too long, leaving a retiree with a lot of money lost in fees and not enough gains to retire in the manner one would like. TDFs adjust their stock/bond weightings based on an individual’s retirement year, when, in fact, the real finish line is the date of one’s death.
But give TDFs due credit. For the many folks who don’t follow markets closely…or who refuse to learn how to invest, TDFs are helpful. They’re even the right approach for folks inclined to frequently change their fund allocation inside a 401(k). Why? TDFs help keep those investors disciplined in their investment choices, which will, more likely than not, enhance returns.
Since my last blog on target-date funds (March 2020), there has been a continuing trend toward lower fees. Most certainly, the annual expense ratio on many TDFs has fallen dramatically over the past decade as they shifted to primarily holding low-cost index funds. If this trend continues, the TDF's hands-off approach to investing will become ever more alluring to the investor community.