Target Retirement Funds
Sensible Investment Strategies
Target retirement funds are also known as target-date retirement funds,
target-maturity funds or life-cycle funds. The popularity of these funds has
dramatically increased since 2004; in fact, target retirement funds account
up to one-half of sales at several fund companies. Let's review the background,
the basics, the pros and cons for these target retirement funds.
Asset allocation funds have existed for many years. Originally, they consisted of stock
funds (both domestic and foreign), bond funds and a money market fund -- all within the same
fund company; the allocations would be
subject to change for general market conditions at the fund managers discretion. Some fund companies have expanded the allocation focus to include various risk
levels of growth objectives and also an income allocation fund.
A few fund companies
(notably T. Rowe Price in the fourth quarter of 2002 and Vanguard in the
fourth quarter of 2003) began to emphasize asset
allocation funds by including an estimated date of retirement.
other words, they believed the basic concept of the fund of funds approach
would be much more marketable to investors if more focus was given to a
specific goal -- retirement! Furthermore, the fund companies believed
that these target retirement funds would appeal to investors who would not
want to either hire an adviser or conduct extensive research by themselves
to obtain portfolio recommendations. This concept also would benefit
companies that have 401(k) plans by (1) simplifying investment decisions by
participants and by (2) eliminating the potential dilemma of fiduciary
responsibility by the company.
Target retirement funds employ a fund of funds approach
with a specific time horizon, reducing the stock fund allocation in favor
of increased bond fund allocation as the target date approaches. The following chart
from T. Rowe Price depicts allocation percentages for stock, bond and cash for years
and after retirement:
Other fund companies may favor different allocation
percentages; some are more conservative with higher bond allocations while
a few are more aggressive with high stock allocations, even with similar
Regardless of the allocations, ideal characteristics for any target retirement fund should
include diversification spread over various stock and bond fund
categories. The target fund should include: large, mid and small-cap
domestic stock funds; foreign stock funds; various corporate, government and
high-yield funds in the bond allocation.
Since all target funds are comprised of individual funds
within the same fund company,
it is important that investors review these underlying holdings. All of
individual funds should have good performance history, well-defined
strategies, experienced managers and below-average operating expenses. Retirement
funds should also be no-load -- there is no reason for investors to pay a
commission for these funds.
For comparison purposes, the
Fund Screen currently splits target retirement funds into five-year
increment groups after year 2010; Morningstar previously had three groups,
but this was too broad-based for accurate comparison ratings. Select "domestic"
under fund type, then select the appropriate target-date range under fund
category along with any other criteria and then click submit.
Rowe Price offers twelve-thirteen individual active-managed funds
(plus one index 500 fund) in their target
fund offerings while Vanguard offers six-seven broad index funds in their target
funds; both companies are no-load. In my opinion, investors do not need
more than fourteen underlying holdings in a target retirement fund since this
would likely lead to fund category overlap (i.e., several funds having the
same characteristics resulting in unnecessary duplication). For a related
topic, go to Three Common
Mistakes in Mutual Fund Investing.
Pros and Cons
Target retirement funds offer a one-stop, easy to use, exposure
for a stock and bond allocation strategy geared for a specific retirement date.
removes the guesswork for effective ongoing diversification and future
rebalancing. These funds are an especially viable choice for 401(k) plans since most
participants (1) do not have access to financial consultation and (2) are
often overwhelmed by the many fund choices and, more importantly, (3) are mystified
by the challenge to determine an
appropriate allocation strategy.
However, the one major disadvantage of target retirement funds is the
absence of different risk tolerance levels (conservative, moderate or aggressive). In
other words, some advisers view these funds as "cookie cutters" in
that one size fits all. For example, since it is unlikely a 401(k) plan will offer
target funds from more than one fund family, this means investors would
choose one target fund that best fits their time horizon, using the level
of risk tolerance that the fund family chooses for that particular target fund
-- their level of risk tolerance may be different from your risk tolerance.
Consequently, one may be undertaking significantly more (or less) risk than
Not all fund companies have similar allocations or fund
categories. For example, across the broad time horizon spectrum, T. Rowe Price
has a higher stock percentage, including a higher concentration of mid-caps
and foreign individual funds than Vanguard, although Vanguard has
significantly narrowed the gap. Some investors may have a very conservative
risk tolerance and may need to include more conservative funds in their
Another potential disadvantage of target retirement funds is the inclusion
of mediocre or poor performing individual funds, which can negatively
affect returns -- always review the long-term past performance of these
individual funds before committing to them. One more potential
disadvantage, especially in view of the general market downturn in 2008
and the first two months in 2009, is the very high percentage of equities
in some target retirement funds for individuals who are soon to retirement
or in retirement -- in these instances, individuals should adjust their
allocation in other
holdings (401k, IRA and/or taxable accounts) to maintain an appropriate overall portfolio allocation.
Note the significant
difference between "target retirement" funds and "retirement income"
funds, most of which were created in 2008: retirement income funds invest
in a mix of stock and bonds and employ a managed-payout strategy.
type of funds promise to make periodic payments until a set expiration date
(e.g., 2020); at that time, your account would be zero. The specific
income payouts, based on a fixed percentage of assets, are not guaranteed
and are subject to the ups and downs of the funds holdings; in addition, the payments
reset annually to reflect the gain or loss for the fund in the previous
year. In contrast, you determine the particulars for any withdrawals in
target retirement funds.
Target retirement funds, especially in a 401(k) plan, present
a worthwhile alternative for investors who can select just one fund and thus
avoid confusion in constructing a portfolio for specifically geared for retirement. In fact, these
funds very likely promote increased participation in 401(k) plans due to their
one-stop simplicity for both diversification and rebalancing for an allocation
Alternatively, investors who either do their own research or have access to an
adviser are more likely to choose a customized portfolio that specifically addresses their
return objectives, time horizon and particular risk tolerance.
Best Types of Mutual Funds for IRA and 401K Portfolios,
Role of Risk in Mutual Fund Strategies and
Changes in Retirement.