The Benefits of Target Retirement Funds
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 startup 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 mean 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 obvious 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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I have my TSP in a target retirement fund right now. Why? For the reasons you stated. I’m a fan of Suze Orman, but I’ve chosen to not follow her advice on this one. Besides, there’s no rule that says once I invest in a target fund that I have to keep my money there for the next 40 years. If I decide when I get closer to retirement that I don’t want things so conservative? I can choose to put my money in a different investment. Easy as that.
@shoyu: Suze Orzman also keeps 99% of her portfolio in bonds. Give ME a break.
I read an interview with Suze Orman on CNNMoney.com:
“Target funds automatically take money out of your stock funds and add it to bond funds just because you’re getting older. Give me a break!”