Target-Date Funds

by James & Miel on December 9, 2009 · 0 comments

When I first started working, the task of determining my 401(k) allocation was quite overwhelming. I was barely out of college and had hardly picked up a financial book and was thus in no position whatsoever to pick the set of funds that were right for me and my retirement goals. A colleague must have noticed my wide eyes and bewildered look and suggested that I put all of my 401(k) money in the Target Fund that best approximated the year at which I will presumably retire. That seemed like a good idea at the time and so I did just that. Within 6 months I had altered my 401(k) allocations to exclude all Target Funds.

Target Funds are predicated on the idea that a diverse portfolio is optimal and that an individual’s investment mix should grow more conservative as they move closer to retirement, and are subsequently built with those two principles in mind.

Diversification – Diversification is one of the primary tenets of investing in general (“don’t put all your eggs in one basket”) and is especially important when attempting to grow your retirement nest egg. It is the primary risk management technique that you will use to ensure that the decline in value of one security will have a minimal effect on the value of the portfolio as a whole.

The critical importance of having a decent chunk of money available when you retire dictates that a diverse portfolio – and thus a safe and stable portfolio – is absolutely essential. There are many ways that you can diversify. You can spread your investments over a variety of different asset types (stocks, bonds, cash, for example), or perhaps you can allocate your assets over a series of funds with varying risk (index funds vs. small-cap funds vs. international funds) or across funds that are representative of different industries.

A solid portfolio strategy would employ all three types of diversification. Target Funds attempt just that. For example, according to Vanguard, my general preferred asset allocation breakdown is as follows: Domestic Stocks (72%), International Stocks (18%) and Nominal Bonds (10%). That asset allocation has some diversity, but it isn’t as diverse as it could be, which introduces risk. But that is done for a reason, and is explained by the next point.

Conservatively Growing Asset Mix – A general rule of thumb is that the longer your investment window, the more risk you should be able to stomach, given that you have enough time to earn back those losses. Conversely, as you grow older and that window shrinks, you should have a more conservative mix of investments, to protect the money that you have spent years earning. So when you (hopefully) start investing young, it’s suggested that you take on more risk in your fund selection (by selecting International Funds, Aggressive Growth Funds and Small-Cap Funds) and then gradually over time move to a more conservative mix (such as Money-Market Accounts, Bond Funds and Balanced Large-Cap Stock Funds).

For example, someone electing to invest in Vanguard’s 2010 Target Fund would see an asset allocation of 40% Domestic Stocks, 40% Nominal Bonds, 10% International Stocks and 10% Inflation-Protected Bonds. That is obviously a much more conservative fund allocation than the one recommended for someone my age.

Given those two principles driving the creation of Target Funds, it would seem to be a good idea to put your 401(k) money in whichever one best approximates your expected retirement date and then relax, knowing that your retirement is managed in the most efficient way possible. Despite some recent evidence to the contrary, fund managers from institutions like Vanguard and Fidelity know more about potential investments and can choose a better asset mix than I could, right? That might be the case, but that doesn’t mean that there aren’t some fair criticisms of those Target Funds.
Target Funds are “funds of funds”, meaning that they are (usually) a mutual fund that is composed of other mutual funds, some of which might also be constructed out of other mutual funds. This has two drawbacks. First of all, there is an inherent layer of complexity to that model which makes it difficult for the common investor to understand where their money is going. An active investor will want to know how his or her money is being allocated, and how each fund within his or her portfolio is performing. Finding out that information from a Target Fund can be a convoluted process, inhibiting the investor from accurately assessing the performance of that Target Fund. Secondly, every mutual fund has certain fees associated with it; having a fund that is constructed out of other funds introduces the possibility that the investor is being charged fees on all levels of the fund. While that isn’t always the case, it does often occur.
Another criticism of Target Fund is that the asset allocated for the target years can vary widely across different fund providers. For example, my suggested fund allocation from Vanguard is as follows: 72% Domestic Stocks, 18% International Stocks and 10% Nominal Bonds. The same target year fund from Fidelity has an asset allocation of 66% Domestic Stocks, 24% International Stocks and 10% Bond Funds. Additionally, the same fund from T. Rowe Price has an allocation of 73.21% Domestic Stocks, 18.7% International Stocks and 8.09% Fixed Income Funds (mostly comprised of bonds). As you can see, there is a reasonable amount of variance between funds offered by each of the three major fund providers.
Finally, there is a concern on my part about Target Funds being filled with bad funds, whose poor performance is washed out by the better performing funds in the mix. This potential problem would exacerbate the problems I described earlier.
For me, personally, the drawbacks are enough for me to favor of selecting my 401(k) allocation rather than relying on a Target Fund. This requires a lot more work on my part, but ultimately, it leads to me being more comfortable with how my retirement dollars are allocated. For some, however, those may not be compelling enough reasons, and if that is the case, then a Target Fund would be an attractive choice. As with any investment, whatever process works best for each investor as an individual should be the one employed.
-Michael

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