What Are Retirement Target-Date Funds and Why Should You Care?

Saving for retirement is hard and keeping track of your investments makes the process even more tedious. Reassessing our risk tolerance is crucial as we age though, which means occasionally rebalancing our retirement portfolios. Sure, you could pay a financial advisor to take care of your 401k, but that’s money very few recent college graduates can pony up. Wouldn’t it be great if an algorithm could rebalance your stock portfolio every year automatically? Well, you’re in luck – that’s exactly what target-date funds do.

Target-Date Funds Do The Work For You

When you have decades of working years ahead of you, taking on risk in the stock market is a good idea. You have compound interest on your side and plenty of time to recover from a downturn. Plus, you’re young! Human capital will grow your bank account more than any type of investment. But as you build a nest egg and creep closer to retirement, a portfolio shock can be devastating. A 34-year old employee aiming to retire at age 65 has more than 30 years to recover from a recession. But a 63-year old doesn’t have that luxury, so risk needs to be toned down toward the end of your working years.

Target-date funds are mutual funds designed to reduce your risk exposure as you get closer to retirement. Also known as life-cycle funds, these products start out heavily invested in stocks and gradually sell them for bonds over a number of years. Let’s like at one of the most popular choices for 20-and-30-something workers, the Vanguard Target Date 2055 (VFFVX).

Chart of Vanguard Target Date retirement fund
Last five years of the Vanguard Target Date 2055 (44.26% return) (Source: Yahoo Finance)

Be warned, there are numbers ahead! The 2055 date isn’t mandatory, but the fund is geared toward people who plan to retire between 2053 and 2057. Since that’s a few decades away, its heavily invested in stocks – 88.4% of the current holdings are equities. Another 10% of the holdings are investment grade corporate bonds (rated BBB or higher), so even the fixed income holdings take on risk. Now let’s look at fund approaching its date – the Vanguard Target Date 2025 (VTTVX):

Chart of Vanguard Target Date retirement funds
Target Date 2055 beat Target Date 2025 handily (Source: Yahoo Finance)

The Target Date 2025 fund has returned more than 26% over the last five years, which is solid but not nearly as sexy as the nearly 45% return from Target Date 2055. Still, that’s the trade-off investors make when choosing a target date fund. Here’s a comparison of the holdings between the two funds.

Asset Allocation TARGET DATE 2055 (VFFVX) TARGET DATE 2025 (VTTVX)
Stocks 88.41% 61.26%
Bonds 9.97% 37.40%
Pct of international stocks 35.84% 24.95%
5-Year Beta (Risk Profile) 1.46 1.07

Target Date 2025 holds fewer stocks which limited returns, but that’s okay. The goal is here capital preservation, not accumulation. Safer American stocks have a higher concentration, while Target Date 2055 invests in more international stocks.

You might be wondering what the heck 5-Year Beta means. Stock analysts use a statistic called beta coefficient to measure risk and volatility. With beta, 1 is the standard market risk in any investment (called systemic risk). Deviations from this number show how wildly the stock price gyrated compared to overall market returns. Target Date 2025 has closely tracked the overall market for the last 5 years, while Target Date 2055 has had more price fluctuations.

Pros of Target-Date Funds

Here’s a few benefits of using target-date funds in your retirement accounts:

  1. Set it and forget it – Investors’ ability to contribute to a target-date fund over a period of decades without much intervention is their biggest selling point. Just contribute to the same fund year after year while reinvesting dividends and your 401k will take care of itself.
  2. Offered by many respectable low-cost brokers – You can find target-date funds at companies like Vanguard, Fidelity, Charles Schwab, BlackRock, and T. Rowe Price.
  3. Perfect for non-investors – Look, I know investing isn’t for everyone. Does the thought of buying stocks make your skin crawl? Then target-date funds are perfect for you! Risk is reduced as you get older and all the rebalancing is done automatically. You don’t have to watch Jim Cramer’s show or read the Wall Street Journal to secure a fruitful financial future.

Cons of Target-Date Funds

Despite the benefits, target-date funds aren’t a perfect solution and there are drawbacks customers should be aware of.

  1. Fees are high compared to index funds – Target date funds are mutual funds, which often come with higher expense ratios than index funds and ETFs. For example, the Vanguard Target Date 2055 has a 0.15 net expense ratio ($15 per every $100,000) while the Vanguard 500 Index Fund ETF (VOO) comes in at 0.03.
  2. Not all funds allocate their assets equally – We looked at Vanguard funds today because they often have the best costs in the industry. But it’s important to shop around! Not all funds targeting the year 2055 invest 88% of their holdings in stocks, let alone the same kinds of companies. Before investing in a target-date fund, always peruse the holdings and make sure the investments match your goals.
  3. Might still be too risky for conservative investors – The Vanguard Target Date 2025 is still holding more than 61% of its assets in stocks. If a sharp downturn occurs, a portfolio of 61% stocks will still take a hit. If you really want to play it safe when retirement approaches, a 50/50 allocation might be preferable. And if you really can’t handle any risk close to retirement, I’d recommend bank CDs or US treasury bonds.

Conclusion

Target-date funds are tremendously useful tools for savers who don’t want to get involved with tracking the markets. When you contribute to a target-date fund, aggressive asset allocation is the focus during the early years. But over time, safe assets like bonds will take on larger and larger portions of the portfolio. Investing can be boring – if looking at these charts makes you go cross-eyed, you might want to consider a target-date fund for retirement.

 

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