TARGET-DATE FUNDS offer one-stop investment shopping. But what exactly are you buying?
These funds are intended to offer a diversified portfolio that’ll carry you through to retirement and beyond. Each follows a “glide path,” reducing its stock exposure over time. But the substantial differences among the funds means that some roads will be rockier than others, so it’s important to understand what you’re getting.
For instance, young investors in 2060 target-date funds—like my children—will have 90% or more in stocks. Over the next four decades, as the targeted 2060 retirement date approaches, that percentage will decline. But at the designated retirement date, some funds will leave 50% in stocks, while others will go as low as 40%.
Target-date funds can be a great set-it-and-forget-it solution for 401(k) and IRA investors. But as you’ll see from the accompanying chart, expense ratios and asset mixes differ significantly. Fund companies typically build their target-date funds by investing in other funds that the firm manages. I’m not aware of any target-date exchange-traded funds, so investors will need to park their money with the fund family that offers their chosen mutual fund. That makes buying these funds more of a commitment.
For this article, I examined three major firms that offer low-cost retirement-date funds—Charles Schwab, Fidelity Investments and Vanguard Group—focusing particularly on their 2020 and 2040 funds. All three have a series of target funds built using index funds. But Fidelity also offers actively managed target funds, while Schwab has a second lineup of target funds that mixes active and index funds.
In their target-date index funds, Vanguard and Fidelity offer the purest approach. While your stock weighting will gradually fall as you age, that exposure comes in the form of total U.S. and total international stock index funds. That means there’s no tweaking of, say, the weight given to emerging markets.
It’s a different story at Schwab, and also among Fidelity’s actively managed target funds. Schwab Target 2020 Index Fund has emerging markets exposure equal to just 1% of its stock holdings, according to Morningstar. By contrast, Fidelity’s actively managed target funds make a huge bet on emerging markets, with Fidelity Freedom 2020 allocating 17% of its stock market money to developing countries.
As I wrote a few months ago, that’s an astonishing overweight—and not one I’m comfortable with, prompting me to cut back on Fidelity’s target-date funds in my 401(k). Vanguard’s founder and the father of indexing, the late Jack Bogle, said funds with higher expenses often take greater risk in hopes that higher returns will obscure their cost to investors. That may be the case with Fidelity’s actively managed target funds.
The differences aren’t just about emerging markets. There are also variations when it comes to things like foreign bonds, credit quality, real estate and commodities exposure.
In Vanguard’s retirement-date products, you’ll find the firm’s Total International Bond Index Fund, which includes slight exposure to emerging markets bonds. For instance, Vanguard Target Retirement 2020 has 13% in overseas bonds. Meanwhile, Schwab’s target funds have no dedicated foreign bond exposure, Fidelity’s active funds have a small allocation and Fidelity’s index funds have none.
What about bond credit quality? Though fixed-income investments are just 6% of its portfolio, the actively managed Fidelity Freedom 2040 Fund takes a couple of steps out on the credit quality limb. According to Morningstar, its overall credit rating is just BB—one notch below investment grade. (AAA is the highest bond rating, followed by AA, A and then BBB, which is the lowest rung of investment grade.) The target funds built using index funds tend to have the best credit rating among those in the accompanying chart, with most at a solid AA.
Schwab apparently believes real estate deserves extra emphasis. Both of its 2040 funds have 8% of their stock holdings in real estate securities, double the 4% in Vanguard’s offering. Meanwhile, alone among the three firms, Fidelity offers dedicated exposure to commodities in its actively managed target funds. For instance, the Fidelity Freedom 2040 Fund has nearly 2.5% in the Fidelity Series Commodity Strategies Fund.
The bottom line: Be sure to check under the hood. Fundamental asset allocation decisions by these big firms will take you on very different journeys as you head toward retirement—and you should make sure you are comfortable with what you’re buying and with the expenses you’ll end up paying.
William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles include Needing to Know, Played for Fools and Right from Wrong. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart.
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A limitation of TDFs is that you can’t modify your allocation as your life circumstances change. Based on research done by Wade Pfau and Michael Kitces (https://www.kitces.com/blog/managing-portfolio-size-effect-with-bond-tent-in-retirement-red-zone/), I believe that most TDFs are too conservative early on. In my humble opinion, for most people it makes sense to be mostly or even entirely in stocks until you are about 10-15 years away from retiring. Then, you need to suddenly ramp up your bond allocation as you approach your retirement date. However, after you’ve been retired for 10 years and are past the highest period of sequence-of-return risk, it’s time to become more aggressive once again and increase the stock allocation. You also need to consider the size of your portfolio, fixed and flexible expenses, whether you are willing to work part time in retirement, whether there’s any flexibility with the retirement date, etc. TDFs don’t allow for this kind of fine tuning.
What you say is true. I don’t own TDFs (except in a small inherited IRA where I don’t want to waste time fiddling with the asset allocation), because I think I can build something on my own more suited to my personal circumstances. Still, for the vast majority of investors — who have neither the inclination to spend time learning the basics of prudent investing nor the assets necessary to hire a good fee-only financial advisor — TDFs are an excellent choice, I believe.
Interesting article. We decided to peel off some assets from our TDFs and invest them in bond funds and cash as we approached RMD time. The last thing you need is to be forced to sell off some equity assets that fell off a cliff and are still way down, in order to fulfill your RMD obligations. Leave them alone to grow back and make the RMD from your conservative investments that held up during the drop.
We have IRAs rolled over from previous jobs at Schwab, but they’re invested in Vanguard 2025. Both of our current employers have their retirement plans with Fidelity, so we have our current contributions in Fidelity 2025. At the moment about 50% of our savings are with each company, so it’s been easy to compare. We’ll likely roll the Fidelity accounts into our Schwab IRAs when we retire in a few years.