Masters Running

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Target Date Funds (Read 32 times)

    Since the use of target date funds for retirement portfolio management came up I thought I would add my two cents in.  I am not a registered financial adviser of any type.  Furthermore, you are solely responsible for your own portfolio and its results.  I make no guarantees following my advice will yield any particular returns.  We are talking about investing in risky assets and that means you may lose a lot of money as well as make a lot.  I cannot predict the future with 100% accuracy.

    With that as a prelude, let me start with some data.  Given what they do, target date funds are a very expensive way to allocate your investments.  I pulled up a spring 2011 article in the Journal of Risk on this topic.  The latest data they have is for 2009.  In that year the average target date fund charged 0.7% per year in management fees and the most expensive one charged 2.3% per year.  Since these values tend to move slowly over time they should be approximately accurate today.  These fees are NOT trivial.  Depending on how you weigh the evidence the equity risk premium is between 4% and 7% per year.  That means the averge target date fund is taking somewhere between 17.5% and 9.3% of what you might hope to earn in stocks over bonds.  If you are in a fund charging closer to 2% the numbers are even more depressing.

    In exchange for giving up a substantial fraction of what you can hope to earn in stocks what do you get in exchange?  A typical target date fund starts with some value like 120 and subtracts your age from it.  That difference is the percentage of the portfolio it will allocate to equities.  So, if you are 65 it will put 55% of your money in stocks and 45% in bonds.  The next year it will weight stocks 54% and bonds 46%.  Different funds have somewhat different rules but all work in roughly this manner.

    The bottom line is that if this is how you want to allocate your portfolio between stocks and bonds you can do it yourself for a LOT less.  For example, Vanguard's Total Stock Mkt Idx Inv (VTSMX) charges 0.17% per year in management fees.  This fund will pretty much duplicate whatever return you can expect to earn with any target date fund that invests primarily in US stocks.  (The VTSMX is the fund's ticker symbol.)  For the fixed income portion of your portfolio you can invest in Vanguard Total's Bond Market Index Inv (VBMFX) which has an expense ratio of 0.22%.  Thus, a 50/50 stock/bond portfolio would have an expense ratio of 0.195% as opposed to the typical target date fund's 0.7%.  In financial terms, that means you pocket every single year an extra 0.6805%.  That is a LOT and it will add up year after year.  What do you have to do in exchange for all this additional money?  If you are having money deposited automatically into the funds once a year you need to change the percentage going into each.  Then every year, or more often if you like, you also have to rebalance your portfolio.  That means selling shares in one fund and moving the money into the other in order to get back to the new stock/bond allocation you want. For example, if stocks go up more than bonds they will then constitute a higher fraction of your portfolio's value than you target amount.  To fix this you will have to sell shares in the stock fund and buy shares in the bond fund.  That is it!  Once a year or so you have to go and make a couple of changes.

    What if you want to get your expenses down even further?  Then you can invest in Exchange Traded Funds (ETFs).  These often have the very lowest expense ratios.  You can move your funds into them by establishing a brokerage account and then buying the shares directly on the stock exchange.  It is actually very easy to do.  I am not going to go into the details here since this post is already long.  However, if people here express enough interest in the details I will be happy to provide them.

    Live like you are dying not like you are afraid to die.

    Drunken Irish Soda Bread and Irish Brown Bread this way -->  http://allrecipes.com/Cook/Twocat

      All good points, but most employer-sponsored plans don't have that many options. The target date funds are designed for people who don't want to or are unable to manage the allocation on their own. These accounts are not perfect, indeed, but as a default investment option, they're much better than money market accounts, which is what a lot of plans used to use.

        I think you are right that these target funds are marketed to employers as a way to get their employees to invest their retirement funds in something other than a money market fund.  As you note, it also true and rather unfortunate that most employees tend to put far to large a fraction of their money into money market funds when left to their own devices.  So as a vehicle for employers to help their employees to avoid this trap a target date fund is quite useful. I am not suggesting employers ban these as an option.

         

        But, even if a target date fund has its place in an employer plan it does not mean investors cannot do a lot better.  If they want the target date fund's allocation they can do it on their own at a much lower cost.  So why not?  Most plans offer an low cost stock index option that can substitute for the VTSMX fund I listed, which will suffice.  Once people leave an employer they can move all of the funds into an IRA and invest it in whatever they want.

         

        Last but not least is the question of whether or not a target date fund's asset allocation is actually "right."  I did not get in to it in my post but the arguments for the X minus your age rule are pretty weak.  A very basic model of life cycle investing yields a rule that is independent of age.  That is you figure out what the right fraction of your portfolio should be in stocks and bonds and then keep your portfolio at those weights for the rest of your life.  The reasons why are somewhat tedious.  But the short answer is most people misunderstand how risk works.  As you approach the date on which you plan to pull your funds, if the market goes down a lot you have less time to "make it up."  But you also have less time in which to see such a drop.  Mathematically, the two balance out and you end up with a rule that says the right allocation when you are 20 is the right one for when you are 80.  You can get models to tilt either more or less conservative as you age by making various assumptions about taxes, bequest motives, lifetime income, social security and the like.

        Live like you are dying not like you are afraid to die.

        Drunken Irish Soda Bread and Irish Brown Bread this way -->  http://allrecipes.com/Cook/Twocat

          Good points, Twocat.

          If folks still want the convenience of Target Date funds, despite the mechanical glide path problems, then Vanguard options were all under 0.2% fees when i checked last summer.  (But I didn't go that route.)  As you point out, those fees can be killers at other places.


          Maniac 505

            Erica:  I'm impressed with all the plans your state offers.  I can imagine education must be a nightmare.  My father worked for the state of California.  Also no social security but an amazing list of investments available.

            I on the other hand, for both my 401A  and 457  have choices of a Washington state bond fund, large cap and small cap equity index funds global and emerging market index funds and a bunch of target date funds.  That's it.  at a recent retirement seminar we were told that it was by design because they didn't want to overwhelm us with too many choices. Roll eyes

             

            For my 401A that came from the private sector, it was 100% employer funded.  for the first 10 years it was not self directed and the Managers were so afraid that they would ever have to report a loss  it was only "invested" in short term bonds and cash.  when we finally had the option to self direct they made available pretty much the universe of Vanguard funds.

             

            twocat: Good discussion,  Thanks.  When I said index funds are a "no brainer"  That was a poor choice of words, and not really what I meant.  Since I was way off topic in the daily thread I was trying to be really brief.  What I was really trying to say was that it might be an easy decision if someone didn't want to spend much time on investment choices.

             

            I am very much an amateur but I have read Jane Bryant Quinn and  John Bogle  amongst others.  I've always done it myself, but When I had a recent meeting with a CFP and he was assessing my risk tolerance he said I hold a record amongst his clients.  I've had something in the market since 1972 and I've never been scared out of it (though some of the dips happened when I was at sea and couldn't do anything anyway)  when I met with him my portfolio was almost 100% equities  (I considered my defined benefit plans and Social security as bond equivalents)

             

            Last but not least is the question of whether or not a target date fund's asset allocation is actually "right."  I did not get in to it in my post but the arguments for the X minus your age rule are pretty weak.  A very basic model of life cycle investing yields a rule that is independent of age.

             

             Twocat,  I find the above interesting.  Please don't go to any trouble, but do you know where I can find  further reading on this that a layman could understand?  As close as I am to my paychecks ending, I probably don't want to make a major philosophy change but It might be interesting to learn more.