The Security and Exchange Commission (SEC) is setting up a new division to oversee new financial products, and this group is starting with target date funds. These are mutual funds usually taking the form of baskets of other mutual funds, designed to target a certain year of retirement. As the year approaches, the fund automatically changes asset allocation, usually between stocks and bonds, to become less risky.
I’ve pointed out some of my concerns with target date funds here before. Mainly, they could be too conservative and it’s easy to hide fees. Mary Schapiro, the head of the SEC, pointed to the exchanges from stocks to bonds. The cost of the sales and purchases is buried in the daily price of the target date fund, and there is currently no good way for customers to understand how much they are being charged for the re-balancing of the portfolio they could do on their own.
Schapiro also noted that there is no standard across companies. A target date fund designed for those who plan to retire in 2050 with one fund manager may have a different allocation between stocks and bonds than a 2050 target date fund with another fund manager.
Here is a comparison of the asset allocations for the funds designed for those retiring in 2050 from Vanguard, Fidelity, and T. Rowe Price.
|
Vanguard |
Fidelity |
T. Rowe Price |
| Domestic Stocks |
72.0% |
69.5% |
67.2% |
| Foreign Stocks |
18.0% |
20.0% |
22.9% |
| Bonds |
10.0% |
10.4% |
7.2% |
| Other
| 0.0% |
0.1% |
2.7% |
The variation seems small but could have an significant effect on returns by retirement in 2050. If target retirement funds were standardized across companies, customers could accurately and easily compare returns between fund managers, understand the level of risk, and have the opportunity to make better investment decisions.
I am not convinced there is a need for this. Any fund’s composition is described in detail in the prospectus and in on a multitude of financial data websites like Yahoo Finance and Google Finance. What isn’t clear are the true fees. We do know that Vanguard’s fee for their 2050 fund is 0.19%, Fidelity’s is 0.82%, and T. Rowe Price’s is 0.79%, but that only tells part of the story. Whenever there is turnover — stocks are sold and other stocks, bonds, or other investments are purchases — fees are generated but wrapped tightly into the daily price of the fund so it is barely noticeable.
Asset re-allocation is the purpose of target date funds. Even if the underlying funds, those in the basket, are low-turnover index funds, the managers may be rearranging the index funds in the basket often. For those disciplined to handle the responsibility of occasional re-balancing themselves, and it’s not that difficult, I suggest avoiding target date funds.
Target date funds have lots of fans because it’s a form of automation, and automation in finances is usually a good thing. There is a danger of automation leading to complacency and a false sense of security. If you choose target date funds, familiarize yourself with the details and evaluate whether the pre-packaged re-allocation system is worth the thousands of dollars or more you could be losing in hidden fees and with a risk profile that doesn’t match your income needs and tolerance.
Would you like to see target date funds standardizes so a “2050 Fund” from one company matches a “2050 Fund” from another company? or should companies be left to determine what strategy is best for their customers?
Photo credit: viZZZual.com
‘Target Date’ Funds Get Senate Scrutiny, Daisy Maxey, Wall Street Journal, October 30, 2009
SEC to look at retirement investing risks, Marketplace, November 3, 2009
About the author: The following is a guest article written by Kevin from No Debt Plan. He writes to help readers eliminate debt, learn how to budget and save, and move themselves towards financial freedom.
The first investment we made in one of our Roth IRAs was in a Vanguard Target Retirement fund. Generally target date retirement funds make good investments; if you are just starting to save for retirement it’s a great investment. Flexo recently shared his reservations about these investments, but today I’ll give you four reasons why we like them.
- It’s an easy start.
- Low investment needed to start.
- You get instant diversification.
- The fund automatically rebalances based on your age.
Let’s look at these individually.
An easy start. You need only one account (Roth IRA, Traditional IRA, taxable investment account, etc.). You invest in one fund. That’s pretty easy to get going and removes a bunch of hurdles.
Low investment needed to start. With any target retirement fund, the only start up cost you have is your minimum investment and then associated expense fees. We opened our Roth IRA with Vanguard because they are known for having low expense fees, and the minimum investments are only $3,000. Once you invest your first $3,000, you can add as little as $100 to your account after that. The kicker is you only need the one fund to get started, which leads us to…
Instant Diversification. The reason you only need one fund starting out, is a target retirement fund gives you a great deal of diversification right off the bat. Let’s take a look at Vanguard’s Target Retirement 2050 Fund (VFIFX) that we are currently invested in:
- 71.61% Vanguard Total Stock Market
- 10.09% Vanguard Total Bond Market
- 9.97% Vanguard European Stock Index
- 4.39% Vanguard Pacific Stock Index
- 3.62% Vanguard Emerging Markets Index
- 0.16% Vanguard Total Stock Market ETF
With one fund, you’re invested in 5 other major investments. Starting out you probably want a large amount of US and International stock exposure. Even if you just wanted these two things you would need two funds to get that diversification. Two funds means two minimum investments. Add additional funds and you add additional minimum investments. Not so with the target retirement fund. One minimum investment and you suddenly have instant diversification.
Automatic Rebalancing. Rebalancing is the act of sitting down once per year and adjusting your portfolio toward your target asset allocation. Let’s say you hold two funds because you want a 50% US stock exposure and 50% International stock exposure. During the last year, it is unlikely the funds have gained and lost exactly the same. So you end the year and US stocks have been up more than International stocks. Your current portfolio weight is 53% US and 47% International.
Doesn’t sound like a big deal, right? Just 3%. Well, over time that gap can get larger and larger until one day you find yourself with a 75/25 allocation — way out of whack.
With a target retirement fund, you don’t have to worry about rebalancing. If 100% of your portfolio was in the fund (not a recommendation, just an example), the fund will rebalance for you every year. As time marches on you will get closer and closer to the target date for the fund. As you get closer, the fund adjusts the portfolio for you to be more conservative.
Let’s compare two of Vanguard’s funds, the Target Retirement 2010 (VTENX) and Target Retirement 2050, to make the point clear. We expect the 2010 fund to have fewer stocks and more bonds/income generating investments than the 2050 portfolio listed above. The 2010 investments include:
- 44.08% Vanguard Total Stock Market Index
- 40.28% Vanguard Total Bond Market Index
- 6.18% Vanguard European Stock Index
- 4.43% Vanguard Inflation-Protected Securities
- 2.69% Vanguard Pacific Stock Index
- 2.27% Vanguard Emerging Markets Stock Index
- 0.05% Vanguard Total Stock Market ETF
The 2010 fund is 55.27% stocks and 44.73% non-stock investments. The 2050 fund is 89.91% stocks and 10.09% bonds. An obviously difference. Over time, the 2050 fund will start to look more and more like the 2010 fund.
What are you waiting for? For all of you new investors out there, I honestly think a Vanguard Target Retirement Fund is one of the best initial investments you could make.
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Target retirement funds are increasing in popularity. The funds, and they may be called “lifecycle funds” or “target date funds” or “age-based funds” or a variety of other terms are mutual funds comprising other mutual funds. The allocation percentages of the constituent mutual funds change as time progresses, theoretically becoming more conservative as you approach your target.
For example, the Vanguard Target Retirement 2050 Fund (VFIFX) is a mutual fund of funds designed for people who expect to retire in the year 2050. You would expect an investment — one that is designed to mirror your investing strategy based on your time horizon — to be quite aggressive in order to make the most of the decades between now and the time you need to access its value.
This reveals the first problem I have with target retirement funds: they are often too conservative. VFIFX contains five other Vanguard mutual funds: Vanguard Total Stock Market Index Fund, Vanguard Total Bond Market Index Fund, Vanguard European Stock Market Index Fund, Vanguard Pacific Stock Index Fund, and Vanguard Emerging Markets Stock Index Fund. As of today, 72% of the fund is invested in the Total Stock Market, 10% is invested in the Total Bond Market, and the remaining 18% is split between the others in amounts hardly meaningful.
I don’t see this as aggressive enough for someone who has such a long time horizon. I would suggest eliminating the bond component entirely and distributing the rest towards the international funds.
My second issue with target retirement funds is how it could lull an investor into a false sense of safety and security. While creating a hands-off approach to investing, it encourages buying and holding which is great for long-term success, but it opens the door to complacency. Your reallocations are on auto-pilot, so if you decide to change your time horizon, you may find yourself under or over-exposed to risk. Also, Vanguard, or which ever management company you choose for your target retirement fund, may decide to change strategies in the future, to the point where their guidelines no longer match your expectations.
Target retirement funds to encompass your entire portfolio. If you’ve chosen the Vanguard Target Retirement 2050 Fund for your entire 401(k) election, but you have a Roth IRA where this fund is not available, then you’re modifying your asset allocation away from that prescribed by Vanguard. If you are comfortable with Vanguard’s exposure to equities in their fund but you decide to invest in VTSMX separately in your Roth IRA, you’ve disturbed your overall asset allocation and opened yourself up to risk you may not have intended for your retirement funds.
Fund managing companies can’t seem to agree on the most appropriate asset allocation for a certain target. I mentioned Vanguard’s current allocation rule for its “2050″ fund. Fidelity has a different strategy for those retiring the same year. The Fidelity Freedom 2050 Fund (FFFHX) invests in 68.5% domestic stock funds, 20.9% international stock funds, and 10.5% bond funds. Overall, this is similar to to Vanguard fund of funds, but the specific composition of the international portion provides a strong enough contrast that could have profound effects over 40 years of investment.
The fees for target retirement funds are usually a combination of the fees of the underlying investments. Rarely, a target retirement fund will add a management fee in addition to the feeds already charged by the funds held. Pay attention to these fees, because they will eat into the value of your investment. With a distant target like 2050, the fees eat into your returns even more.
Over the last few years, “target” retirement funds have become more popular. Vanguard offers a wide selection for those looking to retire between 2005 and 2050 in 5-year increments. Fidelity offers the same options with their “Freedom Funds.”
One would think that the Fidelity Freedom 2020 Fund should be similar to the Vanguard Target Retirement Fund 2020 in terms of asset allocation and risk exposure. They don’t. Each company has its own interpretation of what asset allocation is appropriate. The form of these all-inclusive retirement funds is that the allocations change over time, and funds from different companies will see variations in the timing of these adjustments.
While Vanguard and Fidelity are two of the lower-cost funds, fees vary from company to company. Since target retirement funds are mutual funds containing investments of other mutual funds, not only do you have to deal with the fees of the underlying investments, but sometimes there will be added fees to represent the convenience of having the all-in-one fund.
USA Today has a recent article discussing these target retirement funds. The author suggests identifying these aspects of retirement funds before making any investments.
1. The glide path. How quickly a fund moves from stocks to bonds is called its glide path. Just how the fund family arrives at the glide path is a mixture of mathematics and philosophy. Putnam’s RetirementReady funds, for example, use a mathematical formula to determine their glide paths. The formula considers a person’s earning power and financial assets as two parts of one portfolio.
2. The underlying investments. For example, the Hartford Target Retirement 2020 fund has an 18% stake in Hartford Capital Appreciation, a top-performing large-company stock fund.
On the other hand, the fund also has 4.6% of its assets in Hartford International Opportunities, which has lagged behind 75% of its peers over the past five years, according to Morningstar, the mutual fund trackers.
3. Expenses. If you buy from a broker, A shares will cost you less in the long run than B or C shares. A shares charge an upfront sales charge, or load. B and C shares have no upfront sales charge, but they have higher ongoing expenses. For example, suppose you wanted to invest $100,000 in the John Hancock Lifecycle 2025 fund.
4. More than one. Finally, you might not want to entrust your entire retirement plan to just one target fund, no matter how diversified it is. A truly well-rounded retirement portfolio would mean owning at least two target funds � just to be sure.
The article contains an informative comparison chart. The chart provides important details about funds that target retirement in 2020 provided by Vanguard and Fidelity, as I mentioned earlier, as well as several other companies. There are a wide range of investment possibilities. Some investors may be willing to accept slightly higher fees in return for not having to change your asset allocation manually, but it’s still important to see the difference between the offerings.
Personally, I’ll continue to manage my own asset allocation.
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