Target-Date Funds: Simple, Diverse and Great for the Autopilot Investor

Target-date funds (TDFs) are offered to investors that seek to grow assets over a specified period of time, usually for retirement.

If not by now, you will soon be fully aware of my devotion to the simplicity of index fund investment portfolios. Many of my examples focus on the “early-in-life” saving for retirement by investing in a single index fund to achieve a modicum of financial comfort thirty… 40… 50 years hence. But, of course, there are more ways than one to skin a cat, while maintaining an allegiance to those PDQ Principles I mention so frequently. Let’s consider another increasingly popular approach.

Target-Date Funds

Target-date funds (TDFs) are offered to investors that seek to grow assets over a specified period of time, usually for retirement. Often named for the year in which an individual plans to retire, the fund’s asset allocation becomes a function of the time available to meet the investment objective.The notion behind TGFs is something that, not surprisingly, has a great deal of appeal to me – their 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 weight the stock/bond ratio makes sense along the way. Therein lies the appeal of TGFs. By design they radically adjust 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 prone to putting their investing activities on autopilot. Particularly when the fund’s portfolio is allocated to various index funds. Take the case of a young man hoping to retire in 2065. He would likely choose a more aggressive target-date 2065 fund. An older individual nearing retirement (say in 2025) might choose a more conservative target-date 2025 fund. My fund company of choice, Vanguard, offers a comprehensive series of target-date funds¹, using several index funds as underlying securities for the investment. 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 0.15%. The Fund’s portfolio percentage allocation as of January 31, 2020, stood at 54.2% of assets invested in VG: Total Stock Market Index Fund, 35.6% in VG: Total International Stock Index Fund, 7.1% in VG: Total Bond Market II Index Fun, and 3.1% in VG: Total International Bond Index Fund. In short, a more aggressive 90% in equities and a conservative 10% 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 a low expense ratio of 0.13%. The fund’s portfolio percentage allocation as of January 31, 2019, stood at 36.2% invested in VG: Total Stock Market Index Fund, 23.5% in VG: Total International Stock Index Fund, 28.4% in VG: Total Bond Market II Index Fund, and 11.9% in VG: Total International Bond Index Fund. This is a less volatile, shorter-term mixture of 60% in equities and a more conservative 40% in bonds and cash equivalents.

Note: 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).

Beyond the target date – for folks already in retirement – the Vanguard Target Retirement Income Fund (VTINX) gravitates to an even more conservative, less volatile asset allocation (roughly 18% in domestic equities, 12% in international equities, 37% in domestic bonds, 16% in international bonds, and approximately 17% in short-term TIPS (Treasury Inflation Protected Securities). Its annual expense ratio is a very low .12%. Although I used Vanguard funds in my hypothetical example, a wide variety of marketplace target-date options await the investor – funds with various asset allocation strategies to fit differing risk and management preferences.

Nothing Is Foolproof

The Great Recession of 2008-09 reminded many investors that even for folks close to retirement, TDF’s have their own shortcomings. With all of the talk of their conservative mix of highly diversified investments as retirement nears, they still hold a certain percentage of investments in stock, and they do 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 simply 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. It’s always essential to compare fees, and it goes without saying that any conscientious investor should continue to pay attention to changing market conditions. No approach to investing should relieve us of that duty.

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 there are no panaceas out there. As conditions change in one’s financial life, the types of investment suitable to those changed circumstances might also change.

Coronavirus: Lessons Learned?

According to Morningstar Direct, in 2008, target-date fund portfolios for folks planning to retire in 2010 took a nose-dive of 36% from the market’s October 9, 2007 peak, on average, during the Great Recession (the broad index fell 55% during that crisis). Compared to the current coronavirus scare, from the February 20, 2020 market high through last Thursday, TDF portfolios of folks who planned to retire in 2020 dropped by about 13%, on average. During the Great Recession, the 36% loss by near-retirees in TDFs represented more than two-thirds of the 53% decline suffered by those planning to retire in 30 years. By comparison, losses by today’s investors close to retirement represent about half of the 24% market decline.

Hopefully, lessons were learned from the bitter Great Recession experience. We’ll soon find out.