Target date funds

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 are all-in-one funds that automatically adjust the asset mix of stocks, bonds and cash according to a selected time frame. The funds become more conservative over time, creating a glide path by gradually shifting their asset allocations from equities and into fixed income. Target date funds are useful for retirement saving, and also as age-adjusted portfolios for college savings plans.

Target date funds are designed for people who want simple investment management. These funds make assumptions about their potential investors; one of which is asset allocation, an important investor decision. Although target date funds are designed for investors retiring in a given year (approximately), they are also useful for markedly different retirement dates or for other goals, depending on your particular objectives and risk tolerance.

Target date funds have become increasingly popular over time. Many corporate retirement plans now offer these funds, often as default investment options.

Different providers operate target date funds in different ways. The funds are often structured as funds-of-funds. Some providers only use index funds in their target date funds; others include a (large) portion of active funds. The fund expense ratios differ widely between providers. Some providers, including Vanguard, charge a simple weighted average of the expense ratios of the underlying holdings.

Selecting an adequate target date fund
The Department of Labor recommends that investors consider the following factors when selecting a target date fund:


 * Consider your investment style. Do you want to play an active role in managing your investments, or do you prefer the more hands-off approach of a target date fund? Keep in mind, however, that even with a target date fund, it is important to monitor the fund’s investments over time.
 * Look at the fund’s prospectus to see where the fund will invest your money. Do you understand the strategy and risks of the fund, or of any underlying mutual funds held as investments?
 * Understand how the investments will change over time. Are you comfortable with the fund’s investment mix over time? In particular, make sure you understand when the fund will reach its most conservative investment mix and whether that will occur at or after the target date. Does your level of risk tolerance match how aggressive or conservative it is?
 * Take into account when you will access the money in the fund. How does the fund’s investment mix at the target date and thereafter fit with your plans for the future, whether they are to withdraw your money at retirement, or to continue to invest?
 * Examine the fund’s fees. Do you understand the costs for both the target date fund and for any mutual funds in which the target date fund invests?

When choosing a fund, the Bogleheads recommendation is to ignore the fund's date. Instead, determine the amount of risk you are willing to tolerate, and then work backwards to find a fund that matches the chosen stock/bond allocation. You may be surprised to find a large discrepancy between your planned retirement date and the fund's target date. Remember that the fund does not know you, or your personal risk tolerance.

Diversification
With the purchase of a single fund, you gain exposure to a broad portfolio of US and international stocks, and thousands of US and international bonds. These funds are excellent choices if you do not have enough to meet the initial minimum investments for purchasing separate funds.

Asset allocation on autopilot
Professionals manage the asset allocation, and it changes automatically as the target date gets closer.

Criticisms
Although target date funds provide very simple diversification for their shareholders, there are reasonable criticisms of them.

Mismatch between target retirement year and asset allocation choice
The funds set an asset allocation for a given target date either for education or retirement. Not everybody wants the same allocation, even if they will retire in the same year or target the same year for education expenses. You might find the fund's allocation for your target year is either too aggressive or too conservative.

If you select a target date fund by its current asset allocation, and not the target year, you may find that the fund shifts its asset allocation either too soon or too late.

For example, suppose it is 2010 and you plan to retire in 2030, but you think the 85% stocks 15% allocation in Vanguard Target Retirement 2030 Fund is too aggressive for your need, ability and willingness to take risk. Instead, you like the allocation in Vanguard Target Retirement 2015 Fund, approximately 65% in stocks and 35% in bonds. If you invest in Target Retirement 2015, however, at some time close to 2015, the fund will shift its allocation more conservatively, while you are still at least 15 years away from your planned retirement. On the other hand, if you would like to be more aggressive and invest in Target Retirement 2035 while you plan to retire in 2015, you may find the allocation in Target Retirement 2035 not shifting when you need a less aggressive allocation after you retire.

Tax inefficiency of target date retirement funds
Target date retirement funds include all assets in one fund and do not allow a tax-efficient fund placement of each individual asset class.

These funds all have an increasing and/or large allocation to bonds. Because bond fund distributions are considered ordinary income (that is, they are taxed at your marginal tax rate), you will pay higher taxes than a stock fund (taxed at a lower capital gains rate). Therefore, the most suitable location for target date funds is in tax-advantaged accounts.

If you expect to be in a low tax bracket for the intended holding period, these funds might be appropriate in a taxable account. Investors having both taxable and tax-advantaged accounts are generally better served by splitting their equity and fixed income allocations, concentrating on tax-efficient asset location.

Note: Taxes considerations are secondary to setting your desired asset allocation.

Possible unsatisfactory allocation choices
Depending on your personal preferences, a target date fund's asset allocations could be unsatisfactory. For example:
 * Some providers include active funds, and you may not want this.
 * Providers sometimes change the allocation of their target date funds. If you do not like the new allocation, you might find it awkward to sell the fund, especially in a taxable account where you might face taxes.
 * Certain asset classes may not be represented, for example, high-yield bonds and commodities. Funds often only add inflation-protected securities to their allocation as the target date nears.
 * The funds' asset class weightings do not suit all tastes.
 * Target date funds have a fixed allocation to domestic and international. If you want to decide your domestic/international allocation yourself, you might not find this allocation satisfactory.
 * The portfolios use market cap weighted funds, so they are inappropriate if you plan to value "tilt" your stock allocation.
 * If you plan to hold equity REITs in proportion to the weighting of commercial property in the economy, funds weight REITs allocations only to the extent they appear in Total Stock Market Index.

Expenses
Some mutual fund companies' target date fund expense ratios may include an additional expense ratio, on top of the expense ratios of the underlying funds.

Vanguard target retirement funds
Vanguard builds its target retirement funds primarily with index funds, and charges only the weighted average of the expense ratios associated with the underlying funds. They suit investors who want indexed portfolios and look for low-cost investments.

Despite the already low expense ratios, Vanguard could theoretically create even cheaper versions. The underlying holdings are presently all investor class, but all the funds used already have lower cost admiral share and exchange-traded fund classes. Admiral class target retirement funds would theoretically be useful for shareholders with large balances. On the other hand, Vanguard incurs substantial costs to create and maintain target retirement funds. It does not pass on these costs directly to their shareholders, so that you could view the absence of additional share classes as a sort of reimbursement. Vanguard does offer institutional target date retirement funds for institutional accounts.

Articles

 * William Bernstein on Vanguard's Target Retirement funds: The One-Fund Holy Grail
 * Why the Target Funds are Good Marketing but Lousy Investing by Scott Burns.
 * A Better Mousetrap, Craig L. Israelsen, Financial Advisor Magazine (February 2008)
 * Missing the Target by Craig L. Israelsen and Joseph C. Nagengast, published in Financial Planning Magazine, September 2007.