A Closer Look at Target Retirement Funds and How They May Affect Your Investment Allocation

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Over on Generation X Finance, Jeremy wrote a post titled What Asset Allocation Strategy Do You Use? He offered up three different allocation strategies for visitors to choose from.

I commented that IMO, most investors should stick to the strategic asset allocation, which my readers know I advocate here all the time. But where I think the discussion really heated up was in the comments section.

I’d like to highlight a few of the remarks made by readers and add my two cents:

It is generally considered A Bad Idea(tm) to hold both target-date retirement funds and additional funds. Target-date retirement funds are one-stop shopping, and should hold a little of EVERYTHING: Stocks, bonds, commodities, REITs, etc. If you purchase anything *in addition* to a target-date fund, you’re saying “I, with my limited view of the market and minimal experience in portfolio management, know better the appropriate asset allocation than an investment company with armies of researchers and decades of experience.”

I think this reader got it right. Many investors, especially in their 401(k), use target-date retirement funds inappropriately. They use the target funds as a part of their allocation, when in theory, if you use the target date retirement fund, it should be your only selection.

Possible Side Effects

By commingling your target-date fund, with other normal funds, you end up creating portfolio overlap; changing the true allocation of your retirement assets. In the end, you’re hurting yourself one way or the other.

If you’ve inadvertently made your allocation too conservative, you may be costing yourself performance over the longterm. If you’ve inadvertently created a lot of overlap, then your portfolio may be exposed to unneeded excess market volatility, which could create the emotions that lead to poor decision making down the line.

Jeremy from Generation X does a good job of explaining all, in this lifecycle fund post. And much like him, I’ve seen a lot of mangled retirement allocations in my day. It’s another one of the reasons I wanted to start this blog in the first place.

The objective of lifecycle funds

Target Date retirement funds (or lifecycle funds) are designed for investors to match up their projected retirement date with a fund that has created an asset allocation suited for someone retiring around that year.

For instance, my projected retirement year could be 2040. If I elected to go the route of target retirement funds in my 401(k) then I could invest in something like the T. Rowe Price 2040 (TRRDX), with a current allocation of 89% stocks, 6.5% bonds, and 4.5% cash/other. And that would theoretically satisfy my retirement allocation.

What works for me may not work for you

And for me, age 35 with my risk profile, I’d be pretty happy with that allocation, but that might not be for everyone. Some may want a 100% equity based portfolio or some may want a more conservative mix, something like the T Rowe Price 2010 (TRRAX), with a current allocation of 63.45% stocks, 25.20% bonds, 11.30% cash/other.

It’s important to understand your threshold for risk by properly assessing your risk profile. Although a target retirement fund may match your projected retirement year, the investment allocation may not fit your risk profile.

Another great comment worth looking at:

Second, I took a close look at the expenses for my 401(k) options, and it turns out that I can get a lower expense if I invest my 401(k) in index funds as opposed to the target retirement fund. I am saving some money by adjusting my own asset allocation in my 401(k) instead of paying someone to do so. I check the target fund weights and adjust the 401(k) to match. As part of my end of year review, I will probably take another look at the 401(k) expense to make sure this still holds true.

(Most of these target retirement funds are actually fund of funds. The underlying investment allocation I mentioned (for TRRDX) is built using the different underlying funds from within the T. Rowe Price fund family.)

This particular reader is reducing her expenses by mimicking the fund of fund allocation herself. This is a good way to do it, if you know you’re cutting costs and don’t mind the extra work. If you can’t be bothered with it, then the target retirement fund does it all for you and charges you more to do so, in most cases.

One more comment to look at:

And you make an excellent point, that a fund-of-funds (FoF) can be more expensive than holding the component funds. That’s something that I wish was a little more transparent: when you see the expense ratio on a FoF, is that the *additional* expenses of the FoF, or the *composite* expense of the component funds plus overhead? It makes it difficult to do an apples-to-apples comparison. If anyone can tell me if there’s a way to tell the total cost of ownership of a FoF, I would really appreciate it.

Well, I’ve written a few posts about uncovering the true costs of mutual fund ownership. In this post, written at the end of October, I looked at a mutual fund calculator that I find invaluable. It’s an excellent way to measure the costs associated with any mutual fund, including target retirement fund of funds.

I’ve included the following image snippet from PersonalFund.com, where I examined the aforementioned T. Rowe Price 2040 (TRRDX) target retirement fund. Since we will assume these funds are held in retirement accounts (like a 401(k)) look to the column titled ‘pre-tax‘ when looking for last year’s performance.

In this case, it’s obvious that the Vanguard target retirement funds have lower expenses across the board than those of T. Rowe Price. To learn more about the calculator at PersonalFund.com click on any of these posts:

• The difference between good and great
• My Favorite Mutual Fund Cost Calculator
• Mutual Fund Hidden Fees- the Biggest Culprit is ….

In conclusion

If you decide to go the way of investing in target retirement funds (aka lifecycle funds)…

Before choosing a specific fund, make sure to take a look at the underlying investments. For example, if you’re a growth oriented investor, comfortable with overwhelming equity exposure, over the long haul, then examine the allocation of the target fund that corresponds to your projected retirement date, and see if it jives with your risk profile.

For those of you that are not sure what your risk profile/tolerance is, stay tuned for Thursday’s post…

For more on Target Retirement Funds check out these links:

• Over at fivecentnickel … Vanguard Changes Target Retirement Fund Offerings - a concise post about how Vanguard’s changes affected his decisions.
• Target Date Funds: Retirement Made Easy? - an article that will bring you up to speed on the debate over this approach to retirement investing.

Tags: lifecycle funds, target retirement funds