August 2008
The target-date retirement strategy
Target-date funds, matched to your age, offer an easy way to accumulate money. But you need to aim for a portfolio that also
reflects your risk tolerance
Target-date retirement funds are among the hottest investment products of the past few years. Mutual-fund companies and employee-benefits
administrators are rushing to add them to the investment menus of 401(k) plans, touting them as one-stop shopping for your
retirement security. But for all the fanfare, they're not terribly exciting. Target-date funds are designed as a basic buy-and-hold
investment to be added to until you retire, presumably in or around the target year of the fund you choose.
Although these funds are thought of as autopilot investments, you'll still need to take a peek under their hoods. Different target funds take divergent routes to 2015 and beyond.
A target-date fund, sometimes referred to as a lifestyle fund, is basically a wrapper for a batch of smaller investments whose proportions shift from aggressive to conservative as you approach the target date. Once it reaches that year, the fund typically shifts to an income-producing asset allocation.
This value-added service isn't completely altruistic, of course. By offering a one-stop product for retirement investing, mutual-fund families are hoping to attract most, if not all, of your savings, not just the fund or two that you might have otherwise bought à la carte. Nonetheless, target-date funds are generally a cost-effective approach to investing. Most have annual expense ratios between 0.2 and 0.8 percent a year, comparable to thrifty index funds and certainly cheaper than actively managed funds, whose expenses usually run well in excess of 1 percent annually.
Investing by default
Recent legislation may have motivated your employer to offer target-date funds in its retirement saving plans. In 2006, Congress passed the Pension Protection Act, which encourages employers to automatically enroll new employees into their 401(k) plans unless they choose to opt out. The default contribution of those passive participants was initially set at 3 percent of gross income, and employers were required to put that money into suitable investments for those employees.
Target-date funds are widely viewed as appropriate vehicles for default contributions. Previously, the default option for retirement plans was almost always a money-market fund, an impractical savings tool by itself. Assuming employees even wanted to move beyond that default option, they needed to figure out how to allocate assets and rebalance their portfolio. Although some employees undoubtedly enjoy the hands-on approach to portfolio building (and the ever-increasing variety of funds to choose from), many others find the number and types of choices available to them confusing, and end up letting their money languish in a fund paying little interest. The target-date-fund default option provides a solution for the indecisive and intimidated, and probably quite a few others with inappropriate allocations, by offering instant diversification.
Fine-tuning your choices
Thanks to Congress and some behavioral economists, a lot more Americans are at least facing in the right direction when it comes to investing for retirement. If you like the idea of putting all your eggs into one well-diversified basket that shifts its asset allocation with your age, you can further improve on the concept by examining the components of various target funds and picking the one that most closely matches your appetite for risk.
You can determine your tolerance for risk by taking a short multiple-choice quiz; a good example is the Rutger's Investment Risk Tolerance Quiz. In more than a few cases, investors who go through this exercise find that they are more or less averse to risk than anticipated. So, for instance, if it appears that you like to play it safe, you might put your money in a target fund with a horizon that is short of your expected retirement date by 5 or 10 years. If you have a higher-than-average tolerance for risk, you might want a portfolio that is geared for younger investors because it will stay invested in stocks longer.
Be aware of the differences
Let's assume you have an average risk tolerance. Does this mean you should simply go ahead and invest in a target fund that matches your anticipated year of retirement? That depends on which fund family you're considering. The Consumer Reports Money Lab found some stark differences among the three largest target-date fund groups: those offered by Fidelity, T. Rowe Price, and Vanguard. The three groups account for 80 percent of the target-date business, according to the industry consultant Financial Research Corp.
We'll start with expenses. Predictably, Vanguard is by far the cheapest option, with expense ratios similar to its index funds. T. Rowe Price and Fidelity, on the other hand, charge between 0.6 and 0.8 percent annually, about what you'd pay for a large-cap value fund. However, as you can see in the table on the facing page, Vanguard's lower expenses didn't give it a performance advantage. Overall the funds' performance did not diverge much: In examining the returns of the three groups' 2015, 2025, and 2035 target funds, we found that they differed by no more than 2 percentage points, and usually less.
Looking further, it seems surprising that the returns were so similar given the differences in the funds' portfolios. When you look at the asset allocations, the Freedom Funds from Fidelity appear to be quite conservative, with a higher bond-to-stock ratio in their holdings. Also noteworthy is the cash position, or lack thereof, in the Vanguard portfolios.
But this was just the current snapshot. We also looked at the asset mix of the funds over the past three years (target-date funds are a relatively young industry, without much of a track record). While the stock allocations of the Fidelity and T. Rowe Price funds seemed to be constant over that time, Vanguard managers appear to have had a change of heart—twice (see How much to keep in stocks). In 2007 the fund's managers raised the stock allocation in the Vanguard 2015 fund, then more recently reversed course and returned to their 2006 levels.
This might simply be a symptom of the growing pains in the target-date-fund industry. Or perhaps more worrisome, there might be some performance-chasing as the funds compete with one another to attract your money. This essentially defeats the purpose for glide-path investing. So investors would be wise to periodically check the updates that the fund sends to make sure the autopilot is still on the right course.
Although these funds are thought of as autopilot investments, you'll still need to take a peek under their hoods. Different target funds take divergent routes to 2015 and beyond.
A target-date fund, sometimes referred to as a lifestyle fund, is basically a wrapper for a batch of smaller investments whose proportions shift from aggressive to conservative as you approach the target date. Once it reaches that year, the fund typically shifts to an income-producing asset allocation.
This value-added service isn't completely altruistic, of course. By offering a one-stop product for retirement investing, mutual-fund families are hoping to attract most, if not all, of your savings, not just the fund or two that you might have otherwise bought à la carte. Nonetheless, target-date funds are generally a cost-effective approach to investing. Most have annual expense ratios between 0.2 and 0.8 percent a year, comparable to thrifty index funds and certainly cheaper than actively managed funds, whose expenses usually run well in excess of 1 percent annually.
Investing by default
Recent legislation may have motivated your employer to offer target-date funds in its retirement saving plans. In 2006, Congress passed the Pension Protection Act, which encourages employers to automatically enroll new employees into their 401(k) plans unless they choose to opt out. The default contribution of those passive participants was initially set at 3 percent of gross income, and employers were required to put that money into suitable investments for those employees.
Target-date funds are widely viewed as appropriate vehicles for default contributions. Previously, the default option for retirement plans was almost always a money-market fund, an impractical savings tool by itself. Assuming employees even wanted to move beyond that default option, they needed to figure out how to allocate assets and rebalance their portfolio. Although some employees undoubtedly enjoy the hands-on approach to portfolio building (and the ever-increasing variety of funds to choose from), many others find the number and types of choices available to them confusing, and end up letting their money languish in a fund paying little interest. The target-date-fund default option provides a solution for the indecisive and intimidated, and probably quite a few others with inappropriate allocations, by offering instant diversification.
Fine-tuning your choices
Thanks to Congress and some behavioral economists, a lot more Americans are at least facing in the right direction when it comes to investing for retirement. If you like the idea of putting all your eggs into one well-diversified basket that shifts its asset allocation with your age, you can further improve on the concept by examining the components of various target funds and picking the one that most closely matches your appetite for risk.
You can determine your tolerance for risk by taking a short multiple-choice quiz; a good example is the Rutger's Investment Risk Tolerance Quiz. In more than a few cases, investors who go through this exercise find that they are more or less averse to risk than anticipated. So, for instance, if it appears that you like to play it safe, you might put your money in a target fund with a horizon that is short of your expected retirement date by 5 or 10 years. If you have a higher-than-average tolerance for risk, you might want a portfolio that is geared for younger investors because it will stay invested in stocks longer.
Be aware of the differences
Let's assume you have an average risk tolerance. Does this mean you should simply go ahead and invest in a target fund that matches your anticipated year of retirement? That depends on which fund family you're considering. The Consumer Reports Money Lab found some stark differences among the three largest target-date fund groups: those offered by Fidelity, T. Rowe Price, and Vanguard. The three groups account for 80 percent of the target-date business, according to the industry consultant Financial Research Corp.
We'll start with expenses. Predictably, Vanguard is by far the cheapest option, with expense ratios similar to its index funds. T. Rowe Price and Fidelity, on the other hand, charge between 0.6 and 0.8 percent annually, about what you'd pay for a large-cap value fund. However, as you can see in the table on the facing page, Vanguard's lower expenses didn't give it a performance advantage. Overall the funds' performance did not diverge much: In examining the returns of the three groups' 2015, 2025, and 2035 target funds, we found that they differed by no more than 2 percentage points, and usually less.
Looking further, it seems surprising that the returns were so similar given the differences in the funds' portfolios. When you look at the asset allocations, the Freedom Funds from Fidelity appear to be quite conservative, with a higher bond-to-stock ratio in their holdings. Also noteworthy is the cash position, or lack thereof, in the Vanguard portfolios.
But this was just the current snapshot. We also looked at the asset mix of the funds over the past three years (target-date funds are a relatively young industry, without much of a track record). While the stock allocations of the Fidelity and T. Rowe Price funds seemed to be constant over that time, Vanguard managers appear to have had a change of heart—twice (see How much to keep in stocks). In 2007 the fund's managers raised the stock allocation in the Vanguard 2015 fund, then more recently reversed course and returned to their 2006 levels.
This might simply be a symptom of the growing pains in the target-date-fund industry. Or perhaps more worrisome, there might be some performance-chasing as the funds compete with one another to attract your money. This essentially defeats the purpose for glide-path investing. So investors would be wise to periodically check the updates that the fund sends to make sure the autopilot is still on the right course.
