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We have talked about many things now in the Investing Guide for Beginners series. We have covered index funds in detail. We have also covered several portfolios, such as the Three-Fund portfolio and its variants and a few other lazy portfolios. But there is something we have not covered yet: Target Retirement Funds.
A Target Retirement Fund is like an automated portfolio in itself. It is a fund of funds with some allocation to bonds. And the allocation to bonds is changing over time as the time of retirement is approaching.
Many people are investing for retirement. They may know, for instance, that they want to retire in 20 years. Given that and their age, it is likely that their allocation to bonds will increase over the years until retirement. Most people will do that by changing their bond allocation every few years. Either by rebalancing or by injection of new capital.
There is another way. Target Retirement Funds will automatically change their bond allocation over time.
In this article, I cover Target Retirement Funds. We see what is good with them and what is not.
Target Retirement Funds
A target retirement fund is a mutual fund or an Exchange Traded Fund (ETF). What is very singular about them is that they set a retirement year. For instance, there is a target retirement fund for people who plan to retire in 2050. If you know, more or less, the year you plan to retire, you can select the target retirement fund accordingly.
Such a fund is not a fund of stocks or a fund of bonds, but a fund of funds. A target retirement fund is a portfolio in itself. Most target retirement funds are funds of index funds with low-cost. They are composed of around three or four index funds.
Let’s take Vanguard Target Retirement 2040 Fund as an example. At the time of this writing, it is composed of the following parts:
- Domestic Stocks Fund: 51.50%
- International Stocks Fund: 33.50%
- Domestic Bond Fund: 10.50%
- International Bond Fund: 4.50%
In the case of the Vanguard Fund, of course, it contains only Vanguard funds. But you will find target retirement funds from each primary fund provider.
Over the years, the retirement funds will update their strategy. Generally, they are becoming less and less aggressive over the years until they do not change after retirement.
The main advantage of this kind of fund is simplicity. You only own one fund. When you have money to invest, you always buy this fund. You never have to rebalance. You do not have to think about the allocation. If there is a new trend of investing, it may change in your fund directly. And your fund is managed by professionals. You do not even have to decide how much bonds you want.
What is wrong with Target Retirement Funds?
Target Retirement Funds are very simple and convenient, but they are not perfect. Let’s see a few problems with them.
You may think they are only changing the bond allocation over the years. But this is not true. Target retirement funds change much more than you may think. The biggest problem with them is that they can change many more things than you want. When you start to invest in such a fund, you may like the original allocation. However, this can change. Here are examples from Vanguard:
- In 2006, Vanguard increased the stock allocation of many of their Target Retirement Funds by up to 25%.
- Then, in 2008, Vanguard increased the international allocation of the equity part from 20% to 30% for all their Target Retirement Funds.
- In 2013, Vanguard added some international bonds to all their Target Retirement Funds
- Finally, in 2015, Vanguard increased the international allocation of the equity part from 30% to 40% for all their Target Retirement Funds again.
If you invested before 2006 in a Target Retirement Fund from Vanguard, your allocation would have changed very significantly. You may not have wanted international bonds. You may not have wanted a large allocation to international stocks. But you had no choice in the matter. I think this is a big problem.
They are straightforward to replicate. It is not difficult to do your own Target Retirement Fund. You have to buy the same funds as the Target Retirement Fund. And generally, you can achieve a cheaper overall Total Expense Ratio (TER) than the TER of the Target Retirement Fund itself. And the fund has to publish its allocation at least once a year. So you can still follow a fund if you want.
You may not know the date at which you will retire. It is not easy to know precisely the year at which you can retire. It is likely you have an estimate of the years until retirement. But this estimate may be wrong by a few years (or by many). Either you are too optimistic or too pessimistic, or simply something happens that completely changes your plan for good or for bad.
You cannot change your strategy. If you want to get more aggressive or more conservative, you cannot. You are stuck with the strategy of the Target Retirement Fund. You could sell it and buy a new one, but this will generate capital gains which may be taxed depending on your country.
Also, your asset allocation is decided for you and fixed. A good asset allocation is specific to each investor. Basing your asset allocation only on your retirement date is not optimal.
Finally, you do not have the possibility to hold these funds in the most tax-efficient manner. If you are in the U.S., you may hold index funds in your Roth IRA or your 401K or your regular investment portfolio. They all have different tax implications. Therefore, income funds such as bond funds should not be held in the same container as stocks, for instance. This is not the case in Switzerland, but it is still a problem worth knowing.
Target Retirement Funds are useful investing instruments. With them, you only have to hold a single fund in your portfolio. Every time you have new capital to invest, you buy into the one fund.
But they are an investing instrument for lazy people, in my opinion. If you want to follow precisely a Target Retirement Fund as a template, it is straightforward to replicate it by buying the funds it is made of. And if the fund makes a change you are not comfortable with, you are free to reproduce the change or not. And you can often achieve lower TER than the Target Retirement Fund itself.
I think Target Retirement Funds are taking it a step too far in passive investing. A better way would be to invest through lazy portfolios.
What do you think about Target Retirement Funds? Do you own any of them?