Target date funds
Target date funds 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, implementing a glide path by shifting, over time, their asset allocations from equities toward fixed income. Target date funds include target retirement funds in the retirement plan market, as well as age-adjusted portfolios in the college savings plan market.
Target retirement funds are marketed for investors who want simplicity of managing their investments. These funds make assumptions about their potential investors; one of which is asset allocation, an important decision an investor has to make. While the target retirement funds are ostensibly designed for investors retiring in a given year (approximately), they may be used for markedly different retirement dates or for other goals, depending on a particular shareholder's objectives and risk tolerance.
A growing popular option for retirement plan investors is to use a Target date funds as the investment medium. The funds are now being offered in many corporate retirement plans, often as default investment options.
Target date funds implementation differs per providers. The funds are often structured as funds-of-funds. Some of the providers only use index funds, others include a (large) portion of active funds in their Target date funds. Also in the expense ratio of funds there are large differences between the providers. Some providers, like Vanguard, charge only a weighted averages of the expense ratios associated with 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 the investor is willing to tolerate and work backwards to find a fund that matches the chosen stock/bond allocation. The investor may be surprised to find a large discrepancy between the planned retirement date and the fund's target date. Remember that the fund does not know the individual investor and his personal risk tolerance.
Advantages of Target date funds
With the purchase of a single fund, investors gain exposure to a broad portfolio of US and international stocks, and thousands of US and international bonds. These funds are excellent choices for investors who don't have the required initial minimum investments for purchasing separate funds.
Asset allocation on autopilot
Asset allocation is managed by professionals and it is automatically changed as investors get closer to the target date.
While Target date funds provide very simple diversification for their shareholders, such uniform solutions will necessarily be subject to reasonable criticisms.
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 all investors want the same allocation even if they will retire in the same year or target the same year for education expenses. Some may find the fund's allocation for their target year too aggressive or too conservative.
If these investors select a target date fund by its current asset allocation, and not the target year, they may find that the fund shifts its asset allocation either too soon or too late.
For example, suppose 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, which currently invests 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'd 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 retirements 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. Since bond fund distributions are considered ordinary income (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 there is high likelihood of 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 selecting the desired asset allocation.
Possible unsatisfactory allocation choices
Depending on an investor's personal preferences, the Target date funds' asset allocations could be unsatisfactory. Some example reasons follow.
- The inclusion of active funds by some providers might not be satisfactory for some investors.
- The providers sometimes change the allocation of the Target date funds. Investors who do not like the new allocation might have difficulty selling the Target date funds, especially in a taxable account where taxes might be due.
- Certain asset classes may not be represented, such as high-yield bonds and commodities. Inflation-protected securities are often only added to the funds' allocation as the target date nears.
- The funds' asset class weightings do not suit all tastes.
- The Target date funds have a determined allocation to domestic and international. Investors seeking to decide themselves on domestic/international allocation might not find this allocation satisfactory.
- The portfolios employ asset class funds that are market cap weighted, so the funds are not appropriate for investors desiring to value "tilt" the equity allocation of the stock holdings.
- For investors who wish to hold equity REITs in proportion to the weighting of commercial property in the economy, the funds' REITs allocations are represented only to the extent they appear in Total Stock Market Index.
Some mutual fund companies' target date fund expense ratios may include an additional expense ratio on the fund itself, in addition to the expense ratios of the underlying funds.
Vanguard target retirement funds
Vanguard Target date funds are target retirement funds primarily built with index funds and charging only weighted averages of the expense ratios associated with the underlying funds. Both of these characteristics appeal to investors valuing indexed portfolios and seeking 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 utilized already have lower cost admiral share and exchange-traded fund classes. Admiral class TR funds would theoretically serve individual shareholders with substantial balances. On the other hand, Vanguard incurs substantial costs in creating and maintaining the TR vehicles. These costs are not passed on directly to their shareholders, and the absence of additional share classes could be viewed as a sort of reimbursement. Vanguard does offer institutional target date retirement funds for institutional accounts.
Target retirement indexes
- Dow Jones Target Date Indexes
- Dow Jones Real Return Target Date Indexes
- S&P Target Date Index Series
- 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.