In this post I want to talk about target date funds.
If you open up most company’s 401(k) pamphlets, you’ll likely find something called target date funds, or sometimes called lifecycle funds or target retirement funds.
The names could be different, but the basic concepts are the same.
And in a way, it is the easiest investment choice you’ll ever need to make, if you want to keep things as simple as possible.
It is a favorite to many people because it is a good enough, 85% solution, to the everyday person.
And for the Sandwich Generation, busy with so many juggling responsibilities, this could be the ideal choice if you want to minimize your decision making but still want to make smart financial decisions.
Target Date Fund 101
So, what is a target date fund?
Simply, target date funds are simple funds that automatically diversify your investments for you based on when you plan to retire.
Instead of having to rebalance stocks and bonds, target date funds automatically do this for you.
And in order to do this, the fund is actually what’s known as a “fund of funds.” A collection made up of other funds. And these funds within the target date funds provide automatic diversification.
For example, a target date fund might include a total stock market index fund, an international index fund and an index bond fund. And these funds would own its own share of stocks and bonds based on its profile.
I know. It sounds complicated. But believe it or not, this concept of funds within funds actually makes things very simple for you. Because, instead of having to hold multiple funds, you only need to own one and all the business of appropriate diversification and asset allocation is taken care of for you.
Different From Simple Index Fund, like VTSAX.
Ok, you might be asking. I still don’t get it. If I hold onto a well diversified index fund, like a total stock market index fund am I not well diversified?
Yes… And no.
Target date funds are different from index funds. Index fund gives you good diversification within an asset category that the fund is indexing.
For example, the S&P 500 Index fund is great because instead of holding a few stocks, you are holding onto essentially a share of all 500 companies within that one fund. Companies like Apple, Microsoft, Amazon and even smaller companies like Gap, Under Armour and News Corp.
However, stocks represent just one asset category against other types of asset categories out there. Bonds, Real Estate, Commodities and even Cash represent different asset classes.
Introduction To Asset Allocation
I won’t go into all the details of each asset class and asset allocation in this video, but the simple takeaway is that as you get closer to your retirement age, you can manage the risk of your portfolio by dividing your investment portfolio among different asset categories.
The process of determining which mix of assets to hold in your portfolio is a very personal one.
But a general rule of thumb is that as you get closer to your retirement age, you want to reduce the risk of your portfolio by ideally holding more stable and less return investments like bonds and cash, compared to when you were in your accumulation phase – when you are heavily investing in stocks.
And you do this by rebalancing your funds, oftentimes once a year, so you are aligned to your target asset allocation.
Now if this completely went over your head – no worries.
How Target Date Fund Shines
That is where the target date fund really shines because it does this asset allocation automatically for you.
What a target date fund does is it automatically selects a blend of investments for you based on your age or target retirement date. It will start out with aggressive investments when you are young and then shift to more conservative allocation as you get older.
You don’t have to worry about anything except to just regularly deposit money into your target date fund account.
It doesn’t get any simpler than this.
Deep Dive Into Vanguard’s Target Date Fund, aka Target Retirement Funds
Let’s dive a little further.
If you just google Vanguard and target date funds, you can find a website that lists Vanguard’s 12, what they call the Target Retirement funds.
They range from 2015 to 2065, plus one for those already retired.
All you need to do is simply pick the year you plan to retire, let’s say 65 and select the fund that is closest to that year.
For me, that would be Target Retirement 2045, VTIVX.
Other than investing regularly through your working years and managing your withdrawals when you are ready to retire, there really is nothing else you need to do.
Talk about simple, right?
And let’s go a step further and take a look at what’s within this fund.
As I mentioned earlier, these Target Retirement Funds are “Fund of Funds.” So as you can see here, this Target Retirement Fund 2045 is holding several other funds within it. Four funds specifically.
- The Vanguard Total Stock Market Index Fund
- The Vanguard Total International Stock Index Fund
- The Vanguard Total Bond Market II Index Fund
- The Vanguard Total International Bond Index Fund
Each fund is there because of its different investment objectives. And you can see how much of the total Target Retirement Fund is allocated to each underlying fund as of this time, here to the right.
They are all low-cost index funds and if you watch any of my other videos, you know how much I love VTSAX. And what a great coincidence. VTSAX makes up a good 54% of this Target Retirement Fund!
What this fund will do as you get older and the specific retirement year gets closer, the underlying funds will automatically adjust their allocation. It will steadily become more conservative by allocating more to the Bond Index Funds. You don’t even have to login to your account. All this will happen automatically.
Now when you look at the expense ratio here, it is 0.15%. Compared to a basic index fund like VTSAX which has an expense ratio of 0.04%, is this higher? Yes, ofcourse. However, you have to understand the extra service you are receiving.
As we get older, time will be our most valuable asset. We will only have so many years to spend with our kids, our aging parents, our spouses.
For many of us, this extra expense ratio might be worth the cost.
Cons of Target Date Funds
But I can’t ofcourse leave you here. Let’s talk about some of the downsides of target date funds.
For those of you who might have studied various asset allocation researches out there, you might look at Vanguard or any other investment firms automatic asset allocation and think they are either too aggressive or too conservative.
- You might be a type who feels more comfortable being more equities heavy later in life.
- Or you could be the type who can sleep better at night having more bonds when you are younger because of less volatility.
Whatever the case, if you have a specific preference for your asset allocation, Target Date Funds might be frustrating for you.
Ofcourse, you can always select a target date that allows for the asset allocation you prefer.
For example, if you want to be more conservative, choose a retirement date before your actual retirement year.
Or if you want to be more aggressive, pick a later year.
But if you are the type that likes to control your asset allocation, then I would think you’d rather just purchase index funds directly and manage your allocation manually.
So Are Target Date Funds For You?
So you will need to decide for yourself if Target Date Funds are for you.
They aren’t for everybody because some people like more control over their allocation.
They could be great for you if you are fine with a good enough solution because you rather focus the extra time on more important things in your life.
Regardless, they are an excellent choice for many people because by choosing to go with a Target Date Fund, you will certainly outperform the majority of the active management investments out there.
My recommendation is this. If you are just starting out in your investment journey, and don’t know where to start, I think investing in target date funds is an excellent way to start. This ensures you don’t just sit on the sidelines because you are afraid of making the wrong move.
Remember, it is not about timing the market, but time in the market.
Eventually, as you become more proficient in your personal finance knowledge, I think most of us can design our own portfolios that meet our specific life circumstances, but if you are on the sideline because of analysis paralysis – don’t wait. Start with Target Date Funds and get comfortable investing.
Caveat – Research
Few caveats though. Not all Target Date Funds are created equal. Some are more expensive than others so make sure to check the expense ratio before just jumping in.
And for most of them, there is a minimum to buy into the fund. This can range from $100 to $1,000 for Vanguard Target Retirement Funds.
Target Date Funds have the Financial Tortoise stamp of approval. They are easy, low cost and at the end of the day, they are an effective way to invest for the long run.