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Understanding and Comparing Target-Date Funds for Retirement

Here's a look at 5 leading target-date retirement funds

By Will Healy, InvestorPlace Contributor

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Target-date funds are one retirement strategy for less-active investors. These diversified funds set asset allocations based on a target retirement date. For example, a person born in 1975 and wanting to retire at age 65 would want to invest in a 2040 target-date fund.

Asset allocations often define these targeted funds. New college grads just now entering the workforce might look to a fund with a date of 2065. Retirement for these investors will presumably not occur for about 40 years. Therefore, managers of these funds will typically place almost everything in the stock market–because such young investors can handle a larger amount of risk.

However, someone nearing retirement might own targeted funds with a 2020 or 2025 target date. With little time to make up for a massive plunge in stock values, these funds will allocate a much higher percentage of their assets towards bonds. Once the target year passes, these mutual funds typically transition into income funds which pay investors a cash return and invest mostly in bonds.

Before investing in target-date funds, you should be aware of two facts. First, managers design these target-date funds as the main investment for one’s retirement savings. Hence, trying to diversify (except perhaps to a different company’s targeted funds) could mean an investor takes on too much or too little risk. Second, like other investment vehicles, these target-date funds will likely lose money in some years, especially in longer-dated funds which heavily invest in stocks.

Comparing Target-Date Funds

For purposes of this analysis, I will compare 2040 target-date funds. For the sake of simplicity, I will compare A shares when the company offers multiple funds for an age group. Such a fund will target an investor approximately 43 years of age. If this investor eyes retirement at 65, they would be about halfway between college graduation and retirement. Such an investor still has enough years until retirement that they can invest mostly in stocks. However, they have probably become too old to place everything in small-cap or micro-cap stocks.

Many investment firms operate target-date funds. Vanguard leads this field in terms of assets in the $1 trillion target-date fund market. Fidelity, T. Rowe Price, American Funds, and J.P. Morgan round out the top five companies in this order. However, all vary regarding performance and fees charged.

Finally, these funds have versions designed for target dates around five-year intervals. Due to the similarity of the fund families, this advice applies regardless of the target year. Hence, if your near retirement or just getting started, please look up the version of the fund below corresponding to your desired retirement year.

Management fees for Target-Date Funds

While I would describe the management fees for target-date funds as reasonable, Vanguard comes out as the clear winner if lowest fees serve as the priority. The net expense ratio for the Vanguard Target Retirement 2040 Fund (MUTF:VFORX) stands at only 0.15%.

However, this Vanguard fund possesses less management of its own. It merely acts as a vehicle that passively invests in other Vanguard funds. Hence, the fund merely passes down the expense ratio from those other funds.

By contrast, actively managed target-date funds carry higher, but similar fees. The Fidelity Freedom 2040 Fund  (MUTF:FFFFX) charges a 0.75% net expense ratio.  The T. Rowe Price Target 2040 Fund (MUTF:TRHRX) levies a similar 0.74% net expense ratio. American Funds 2040 Target Date Retirement Fund Class A (MUTF:AAGTX) has a net expense ratio of 0.73%. The JPMorgan SmartRetirement 2040 Fund Class A (MUTF:SMTAX) sets a net expense ratio of 0.89%, the most expensive in the group.

Target-Date Fund Returns

Finding the average highest returns for target-date funds often depends on the year. Investors need to also keep in mind that these funds are a relatively new concept. The oldest of these funds, the Fidelity 2040 fund, came about in 2000. Also, T. Rowe Price did not offer such funds until 2013, and as such only lists average returns up to five years.

As for one-year returns, the American Funds posted the highest yield at 12.4%. It came in almost a full percentage point ahead of the Fidelity fund at 11.5%. The Vanguard fund became the only other one to post a double-digit return. Lagging in performance was the T. Rowe Price fund, although it still earned 8.5%.

However, prospective buyers need to also look at longer timeframes. When looking at five-year average returns, American Funds’ AAGTX again led the pack. The American Funds mutual fund posted an average yield of 10.7%. However, returns here were much closer. Fidelity and Vanguard came in at just under 10.1%. Even the lowest performer, in this case, the JPMorgan fund, posted an average return of 9.5%. So, here we see only a 1.2 percentage point spread between the extremes.

If we look at average 10-year performance, these numbers come in lower because as of now, they incorporate the effects of the 2008 financial crisis. Again, the results came in reasonably close. The top performer again is AAGTX at an 8.6% average. Fidelity, the lowest performer over the last 10 years, comes in at 7.3%. JPMorgan came in at an 8.2% average, while Vanguard posted an average of 8.1% over the same period.

Asset Allocation

In my view, the biggest drawback of target-date funds involves a tendency by investors to overlook the actual investments. As mentioned earlier, the Vanguard fund acts as the most passively managed fund. T. Rowe Price’s TRHRX stands out as the most conservative. It contains the lowest percentage of U.S. stocks and foreign stocks (45.8% and 25.1% respectively) and also the highest percentage of bond funds (24.6%). All of the other funds carry approximately 50% of their assets in U.S. stocks and over 30% of their funds in foreign stocks.

The selected target-date funds also carry a low percentage in bond funds. The J.P. Morgan fund carries 18.7% of their assets in bonds. Fidelity’s bond percentage stands at 7.2%. The other two carry bond percentages in the low double-digits. Given that retirement is about 22 years out for holders of this fund, I agree with keeping bond percentages low.

All funds in this analysis carry at least 75% of their stock assets in giant or large-cap stocks. Regarding small and micro caps only Fidelity (8.9%) and Vanguard (6.2%) placed more than 5% of stock funds in these asset classes. I see that as an appropriate approach to risk at this stage.

The Bottom Line for Target-Date Funds

Regarding performance, these target-date funds match one another closely. If I have to choose one, I would have to give the nod to Vanguard’s VFORX, but only by very little. Although America Fund’s AAGTX logged the highest performance on all measures, its management fees come in 0.58 percentage points higher. The 10-year average performance for AAGTX exceeded that of VFORX by only about 0.5 percentage points.

However, as mutual fund owners commonly hear, “past performance is no guarantee of future results.” Vanguard’s tradeoff of less active management in exchange for a lower expense ratio only paid off by a minuscule amount over a long time horizon. American Funds and their active managers logged higher returns over one-year and five-year periods. Moreover, investors should remember that any of these funds could potentially hire the next Warren Buffett and start outperforming their peers.

Furthermore, keep in mind that the window for higher returns continues to narrow slowly. As the year 2040 comes closer, the funds will lower the stock allocations and increase their investments in bonds. For this reason, returns will likely trend gradually lower.

Whatever happens, check returns periodically, and do not hesitate to compare them with competing target-date funds. If one wants to diversify, one can buy any fund or even all of the above. Just keep to the same target date to appropriately allocate risk. Holding to this approach should bring both simplicity and returns for one’s retirement nest egg.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.


Article printed from InvestorPlace Media, https://investorplace.com/2018/09/understanding-comparing-target-date-funds-retirement-invtlk/.

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