The best deal in America: the target-date retirement fund
- July 10, 2010
- 6 comments
- Posted in Investing, Latest Posts
Target-date retirement funds took a bad rap during the 2008-09 market meltdown. Some investors apparently thought that they wouldn’t lose any money in the funds or that they were sure to be safe at the target date.
Misunderstandings like these show the need for more information about how target funds work. The Securities and Exchange Commission proposed some useful new marketing and disclosure rules last month.
But don’t let those discussions deter you from making an investment now. Target funds are the best invention since the index fund for people building retirement savings. Combining the two — index funds inside a target-date fund — creates a winner.
A target-date fund is one-stop investment shop. It contains a mix of stock funds and bond funds that are appropriate for your age. When you’re younger, the mix leans heavily toward stocks, with bonds for a bit of ballast. As you age, the percentage of stocks declines and safer investments come to the fore. If you had a personal money manager, that’s exactly the program he or she would follow.
You don’t have to lift a finger to diversify. The target-date managers do it for you. Your fund’s equity portion will include stocks invested in large and small companies in the U.S., Europe, and the emerging countries of Latin America and Southeast Asia. The bond portion will include Treasuries, high-quality corporates, and perhaps some foreign-country debt. The managers rebalance the portfolio regularly, to be sure that you don’t have too much (or too little) equity for your age.
The only trick to investing in target funds is making an appropriate choice. They’re labeled by year — say, 2015, 2020, 2025, 2030, 2035, and so on. Choose the fund whose date falls the closest to the time you’ll be 65. In that target year, your fund should be planning to hold no more than 45 to 50 percent in stocks (check it out).
If the market falls, the stock portion of your target-date fund will do down too. But the value of your bonds should rise. That’s what diversification is all about. Your stocks will recover, given time.
The only way to avoid stock-market risk is to hold all your money in bonds and cash. At retirement, however, you might have another 30-plus years of life to enjoy. Unless you’re very rich, fixed-income investments won’t see you through. Bonds are the right choice of covering your expenses during the 10 years right after you retire but you’ll need stocks to grow a nest egg for your later years.
In theory, investors could create their own target-date funds. Pick a mix of stock and bond funds and adjust the mix as you age. The problem is that we’re rarely as good at allocating assets as the professionals are. We forget to rebalance and we’re easily scared into selling stocks at the wrong time. Owning a target-date fund is like having a personal investment adviser, at practically no cost. You just choose a good date, invest regularly, and let the process work.
When your fund reaches its target date, you have two choices: sell the assets (or roll them over in a tax-deferred account) and invest in a different mix of stocks and bonds, or leave the money where it is. If you stick, your fund will gradually acquire more bonds. When you’re about 80, it becomes an income fund.
What’s the best target-date fund? There are two competing philosophies — low cost and high growth.
The Vanguard Group goes for low cost. Its suite of Target Retirement funds are invested in various types of stock and bond index funds. They’re the industry’s lowest in cost — just 0.18 percent a year — which gives you the highest net return for the level of risk you take. At 65, you’ll be half in U.S. and international stocks and half in bonds.
T. Rowe Price’s Retirement Funds go for growth. They’re more aggressive than Vanguard’s — at age 65, you’ll be 55 percent in stocks (perhaps more). They’re also more expensive. You’re invested primarily in funds run by individual managers at a cost of roughly 0.65 to 0.75 percent a year. A higher allocation to stocks means wider swings in the value of the funds. It should also mean more assets for the future and perhaps a larger legacy for your kids.
A target-date retirement fund is the only retirement investment you’ll need. Let the manager run the money while you get on with the rest of your life.
Tags: target-date funds
Jane,
I followed your tweet to this well-written post.
I second your view: target date funds are the best invention since index funds.
However, not all target date funds are created equal. Some like to put low quality high yield bonds in the bond allocation. This would make the funds look good in normal time but would cost investors a great deal in bad time.
As the past two years taught us: high yield bonds can drop like stocks.
Good point. I will be writing more about target funds.
Dear Jane: I currently contribute to Vanguard Target 2020 fund.I am on the fence about continuing.What do you think about taking the same asest allocation percentage in the 2020 fund and instead channel the money in Vanguards Total Stock Index and Total Bond Funds? Since inception 7%and 6% returns respectively.
Thank you.
Steve
A perfectly good strategy, provided that you keep rebalancing, to keep the same percentages, and choosing more conservative investments as you age. The Target fund does that for you automatically.
Hi Jane,
I got out of the market in the Spring of 2008 and am looking at getting back in through these target funds. Speaking of not all funds being equal, what do you think of Vanguard’s 2025? Am on the fence about whether to go for it or the 2030 since we might need to work longer to retire. Do you think it makes sense to be more agressive in one’s picks of retirement target dates at this stage?
Thanks,
Nikki
Personally, I go for the date closest to age 65, whether you’re working or not. You can’t predict your retirement age because it’s often out of your control (job loss, illness). So structure your portfolio to be age appropriate.