Are target retirement funds the one-size-fits-all investment choice they appear to be? Maybe, maybe not. Here are 10 things Paul Merriman thinks you should know before you invest.
 

Target retirement funds are mutual funds that automatically become more conservative as their shareholders approach retirement. Most are structured as funds of funds, each one investing in several mutual funds within a single fund family.

Many mutual fund providers offer target retirement funds. The three most prominent no-load families in this segment are Vanguard, Fidelity and T. Rowe Price. Target retirement funds are usually named to coincide with investors’ expected retirement dates, e.g. the Fidelity Freedom 2025 Fund.

Because of their sheer simplicity, I believe target retirement funds deserve a look. They offer a one-purchase solution to diversifying among various asset classes. They also relieve investors of the need to actively rebalance their assets and think about shifting toward more conservative investments as retirement draws closer.

But target retirement funds may not be the best choice for everyone. Here are 10 things you should know about these funds before you make a decision:

No. 1: Target retirement funds require only one simple decision.

If you know when you expect to retire, you can choose among a handful of target retirement funds fairly easily. This is good news to investors who are daunted by the prospect of sifting through some 10,000 potential offerings.

In choosing one of these funds, it’s not necessary to know your precise retirement year. The differences between, say, a 2025 fund and a 2035 fund isn’t rocket science. If you are within four or five years of the date in a particular fund’s name, you’ll probably be in the right ballpark.

No. 2: These funds relieve you of the responsibility of figuring out asset allocation.

When you invest in a particular target retirement fund, your money will be allocated among stocks, bonds and cash equivalents.

The farther you are from retirement, the more the fund is likely to have invested in stock funds. As you get closer, you’ll gradually have more in bond funds – without having to make any decisions about it. Unless your retirement date changes, with a target retirement fund you can make your initial purchase and then forget about it.

No. 3: Target retirement funds rebalance automatically to keep risk levels in check.

When a particular asset class has done especially well, it can create a bulge in your portfolio. This bulge increases your exposure to the risk of a downturn in that particular type of asset. Standard investment advice is to periodically rebalance to return to age-appropriate risk levels. Target retirement funds do this automatically for their shareholders. This forces the fund managers to buy low and sell high. What a concept!

No. 4: Target retirement funds are relatively inexpensive.

Although investors pay their share of the normal expenses in the underlying funds in the portfolios of target retirement funds, usually there’s little or no extra expense for consolidating them. Vanguard, with its legendary low expense ratios, is the clear leader in this respect. Fidelity and T. Rowe Price also have inexpensive target retirement funds.

No. 5: Target retirement funds are continuing to improve.  

Managers of these funds are improving their asset allocation choices. A welcome trend involves more aggressive portfolios for shareholders with decades to go before retirement. This makes a lot of sense. I can’t see much reason for most investors in their 20s and 30s to own bonds and cash equivalents in their retirement portfolios.

No. 6: Most target retirement funds are too cautious for young investors.

In the long run, investors get paid for taking risks. Target retirement funds have tended to avoid risks even for shareholders with decades to go before retirement. For example, the 2045 retirement funds offered by Vanguard, T. Rowe Price and Fidelity have about 10 percent of their portfolios in bonds.

I don’t think this makes much sense. Ten percent in bonds isn’t enough to provide any meaningful cushion in a bear market. Yet lower returns on bonds can cost an investor tens of thousands of dollars over an investing lifetime.

No. 7: Most target retirement funds are too conservative for many retirees.

The tendency of target retirement funds tend to err on the side of being conservative can be costly to retirees as well. Many retirees live into their 90s, and they need their money to last at least as long as they do.

An extra 10 percent in equities in a retirement portfolio can make a significant lifestyle difference in the long run. Retirees might not get that difference if they let fund managers make choices for them. (For more on this, read my article “Retirement: When your portfolio starts paying you.”)

No. 8: Target retirement funds tend to invest too much in large-cap growth stocks.

Of all the equity asset classes we recommend, large-cap growth stocks have the poorest long-term return record. Yet target funds load up on these popular assets while they skimp on value stocks and small-cap stocks which over long periods of time have turned in superior returns.

The typical target retirement fund has about 6 percent of its equity portfolio invested in small-cap stocks and about 10 percent in value stocks. (I recommend much more than that.) This means young investors are giving up an extra one to three percentage points of annual return that I believe they could get without taking additional risks. Over 30 or 40 years, that can make a huge difference in the size of a retirement nest egg.

No. 9: Target retirement funds usually invest too much in U.S. stocks.

I believe that 40 to 50 percent of the equity part of a well-diversified portfolio should be in international stocks. The typical target retirement fund allocates only about 20 percent outside the United States.

International stocks don’t necessarily turn in higher returns than U.S. stocks (although that has frequently been the case in recent years). But international stocks fluctuate in value at different times and different rates, offering a fine way to decrease the risk of volatility.

No. 10: Target retirement funds ignore everything in a shareholder’s life except an expected retirement date.  

Many people have investments in various taxable and tax-deferred accounts. Yet the managers of target funds have to assume they are managing 100 percent of their shareholders’ money.

These funds are often viewed as being tailored to investors’ needs; however, this “tailoring” is based on the notion that only one fact matters in a shareholder’s life: the expected retirement date. They don’t take other resources into account. They don’t take individual risk tolerance into account.

Target retirement funds can play a useful role as core holdings, particularly in 401(k) or similar accounts. But they don’t provide everything that investors need.