Target Retirement Funds

If you’re looking for an ultra easy and effective investment vehicle for your retirement money, you should definitely consider the Vanguard Target Retirement Plans. There are a bunch of them with various dates of when you would retire. For instance, one is called the Vanguard Target Retirement 2040. It starts out with an asset allocation heavily favoring equities and gradually shifts to fixed income as you get closer to the year 2040.


Here is the current versus 2040 asset allocation of this Vanguard fund.

This is the likely shift in mix that you would implement yourself over the years to reduce the volatility of your position and to generate more income for retirement spending.

In the long run, index funds will generally beat 80+% (probably more like 90+% on a post-tax basis) of actively managed funds due to their low cost structure and low tax drag. There is a lot of research done which has supported this point.

Advantages of using this fund:

  • No management required by you — just set up your automatic monthly deposit into this account and you’ll be in good shape for retirement savings with very high probability

  • Very low cost (0.21% expense ratio) and low underlying turnover since they are index funds (this will reduce the year to year tax hit on your earnings as well as the trading costs incurred by high turnover). This expense ratio is extremely low — the cheapest index funds are about 0.1% while actively managed mutual funds will range from 0.75% to 2%. We believe that investing in low cost funds is vital.

  • Good diversification

  • Vanguard handles all the rebalancing and the gradual portfolio shift to a higher percent of fixed income over the years

Drawbacks

  • You lose control over the exact asset allocation — so if you believe that you want more emerging market exposure, you would have to do that with another fund.

  • If you control your asset allocation and rebalancing through multiple funds, you can boost your returns a bit by being smarter about reducing the tax costs (by using ETFs, leveraging your tax-free retirement accounts, etc.). If you plan to do all your retirement savings through tax-free IRA and 401K accounts, then this point is less important. Take a look at Portfolio Management Complexity for more information


Warning: other funds offer these plans but they are not all the same. Fidelity has its Freedom funds which are similar but they have two key differences. First, they are higher cost (0.76% in total expense ratio vs. 0.21% for Vanguard). Secondly, they invest in all Fidelity actively managed funds instead of index funds. These funds will generally have higher turnover of their underlying securities and this will create a larger tax drag on your performance (as well as greater trading costs). We don’t see any reason to believe that the Fidelity actively managed funds would outperform the index funds over the long run. Thus, you’re just giving up those extra costs.

While the expense figures seem very similar and the tax costs might not be hugely different on a one year basis, these smaller differences compound into very meaningful numbers over 35 years. The difference between earning a 6% annual real return over 35 years versus a 7% annual real return is large. If you invest $100K today and earn a 6.24% annual real return (7% minus 0.76% in expenses) on it over 35 years, you would have about $832K at the end of the 35 years. However, if you earn a 6.79% real return (7% minus 0.21% in expenses), you would have $996K at the end of period. That's a substantial difference.