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.