Approximating Vanguard target date funds

 seeks to help investors who are saving and investing in an employer provided plan and are interested in creating the asset allocations supplied by Vanguard's recommended four-fund portfolios  or, by eliminating the international bonds allocation, recreating the  popular and often recommended  three-fund indexed portfolio    A key aspect of these portfolios is that they are comprised of total market index funds  Advocates of these portfolios prefer total market funds, in part, because they limit the number of funds needed to invest in the markets.

If you are fortunate enough to have an employer plan that provides a wide selection of low-cost indexed target date retirement funds, along with a selection of low-cost asset class index funds, you will likely have little trouble implementing these three-fund or four-fund portfolios. At worst, you should succeed in closely approximating one of them with a limited number of funds. For example, Forum discussion 401k investment offers the options displayed in the table below. These include Vanguard target retirement funds plus additional standalone funds (open the table for a listing of fund options and expense ratios).

In this instance, the investor has the option of selecting a portfolio of Vanguard target retirement funds, which naturally holds four total market funds, or fashioning a portfolio from the following stand-alone index funds, which reconstitute three total market funds, sufficient for creating a three-fund portfolio. An investor would need to hold the international bond asset class in another account.

However, many investors are forced to participate in plans that have high costs, plentiful fund offerings but few index fund options, and problematic target date retirement funds. In this environment, crafting the simple, low cost three-fund or four-fund portfolio can be a more difficult task.

A main tenet of portfolio allocation advice typically tendered on the Bogleheads forum is the assumption that investing in the total market is the aspirant goal of the investor, and that if the investor is forced to invest in only segments of the total market due to the limitations of fund selections in a retirement plan, then the total market allocation is to be met by using complementary funds that approximate the total market. (See Approximating total stock market and Approximating total international stock market for examples of reconstituting a total market allocation from constituent index funds).

Four-fund portfolio
Vanguard recommends a core portfolio comprising four asset classes. The four asset class index funds making up this buy-hold-and rebalance portfolio are:
 * A US total stock market index fund
 * A total international stock market index fund
 * A US total bond market index fund
 * A total international bond market index fund

The Vanguard target date retirement funds are four-fund portfolios. Prior to Vanguard's addition to international bonds, the target funds held the three-fund portfolio outlined below.

Three-fund portfolio
The three-fund portfolio attempts to simplify the investing process by utilizing three total market index funds holding broadly diversified stock and bond investments. The portfolio is meant to be a buy-hold-and rebalance portfolio. The three asset class index funds required for this portfolio are listed below.
 * A US total stock market index fund
 * A total international stock market index fund
 * A US total bond market index fund

Total market funds
The three-fund and four-fund portfolios have one thing in common: Every index fund name contains "total." This section defines the "total" index fund compositions.

US total stock market funds
These funds invest in the investable US public stock markets, weighing stocks according to their market capitalization. They will include large-cap, mid-cap, and small-cap stocks. A commonly encountered situation for many retirement plan investors is to find only an S&P 500 index fund in their retirement plans. To attain total market exposure, the investor would need to add a completion index fund, or a combination of mid cap and small cap index funds.

In some instances, investors may have these funds within their plans. The Thrift Savings Plan, the federal workers retirement savings plan, for example, offers both an S&P 500 index fund and an extended market completion index fund. Some plans may also offer an S&P 400 mid-cap index fund and an S&P 600 small-cap index fund which opens up the opportunity to approximate the US total market. If the plan does not have suitable options to capture the rest of market, investors may be able to do so by:
 * 1) Investing in these completion indexes in a personal retirement plan or taxable account;
 * 2) If married, invest in these completion indexes in the spouse's accounts.
 * 3) If married, forgo investing in the S&P 500 fund and hold the total market fund allocation in one of the spouse's accounts.

Total international stock market index fund
The most complete total international index funds invest in both developed market and emerging market stocks, and hold market allocations to large-cap, mid-cap, and small-cap stocks. Some international index funds will only cover developed markets, and many international index funds only include large-cap and mid-cap stocks. In these instances, investors may consider adding emerging market and small cap international index funds. Depending on the availability of these index funds, investors might be able to add them in their employer's plan, in their individual retirement plans or taxable accounts, or if married, in their spouse's accounts.

Total US bond index funds
In the US, a total bond index is commonly benchmarked to the Barclays Capital US Aggregate Bond Index, which benchmarks investment grade taxable bonds. These include treasury and government agency bonds, investment grade corporate bonds, mortgage-backed securities and asset-backed securities. The index does not include Treasury inflation protected securities, high yield bonds, floating rate bonds, or municipal bonds. The total US bond market index has an intermediate term duration.

Total international bond index funds
Most forum investors will be considering the Vanguard international bond index fund, which is hedged against currencies, and invests in international government, agency, and corporate bonds, primarily from developed countries. The index has an intermediate term duration.

Target retirement funds
The default option for employer provider plans is to place your contributions and employer matches into a target date retirement fund.

Empirically, investor allocation to target retirement funds has been increasing. Vanguard reports data for the employer provided funds it manages in annual 'How America Saves" studies. Among the findings:
 * Employee account balance holdings of target retirement funds has increased from a 3% allocation in 2006 to a 17% allocation in 2012.
 * Employee contributions to target retirement funds has increased from 4% in 2006 to 31% allocation in 2012.
 * In 2012, employees 25 years old and younger held 68% of their account balances in target retirement funds.
 * In 2012, employees with less than 10,000 dollars in their plans held 56% of their account balances in target retirement funds.

Approximating a Vanguard target date fund
Below is an illustrative example of a 401(k) plan. There are several reasons why it was chosen, since it provides a menu of funds that illustrate how to approximate total market positions from available plan options. The plan has:


 * A lot of choices.
 * Target retirement funds, but in this case they would be deemed inappropriate because they are Fidelity Freedom® Funds that use 24 active funds.
 * A Balanced fund, Fidelity® Four-in-One Index Fund, which approximates three quarters of the Vanguard Target Retirement fund (lacks international bonds) but comes with the limitation of having only one asset allocation (85% stocks/ 14% bonds).
 * U.S. and international stock total market indexes and a US bond index that match three quarters of the Vanguard target retirement fund and fulfill the requirements for a three-fund portfolio.
 * A developed international market index.
 * Additional bond indexes.

(Open table for a complete listing of fund choices and expense ratios.)

No U.S. total stock market index is available (option 1)
If the plan did not hold the U.S. total stock market index fund, an investor could use the available completion index fund and reconstitute the total US market slice of the portfolio as follows:

S&P 500 with completion index.

No U.S. total stock market index is available (option 2)
If the plan held neither the U.S. total stock market index nor the completion index fund, the investor could use the available small-cap and mid-cap index funds to approximate the US total market index:

S&P 500 with a mid-cap and small-cap index.

No U.S. total stock market index is available (option 3)
The plan only has an S&P 500 index. The investor would need to use a completion index, or a combination of small-cap and mid-cap indexes held in other accounts (personal retirement accounts, a taxable account, or if married, one of the spouse's accounts to approximate a total market position.

No international stock market index is available
The plan only has a developed market international index. To partially reconstitute an approximation of the total international, the investor would need to add an emerging market index fund to the portfolio in another account. To more fully reconstitute the total market approximation, the investor would also need to add a global-ex U.S. small cap international index fund in another account.

No U.S. total bond market index is available
The plan has a U.S. intermediate-term Treasury bond index available that provides the portfolio with an investment grade intermediate bond allocation. If the investor wishes to diversify the bond allocation, this can be accomplished by holding additional bond funds in other accounts.

Approximating the international bond allocation
Unfortunately this plan does not provide an international bond allocation. The investor would need to to add an international bond allocation in another account.