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Target Retirement Funds: A Good Option for Your Retirement?

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Target retirement funds (also known as target-date or life cycle funds) are designed to be stand-alone retirement investments. These funds, offered by several companies such as Vanguard and T. Rowe Price, gradually shift your asset allocation over time from a growth-oriented approach when you're young to a lower-risk conservative portfolio as you get older.

How target retirement funds work

In a nutshell, a target retirement fund is a form of mutual fund or ETF that shifts its asset allocation over time, automating the retirement investing process. These funds have become incredibly popular in recent years, and are expected to make up half of all defined-contribution retirement assets by 2020.

Stock-based funds are relatively volatile, but also have high long-term growth potential. Bond funds tend to be less volatile, but also tend to produce lower returns, since their focus is income as opposed to growth. And, some target retirement funds also use cash or equivalent funds, which can produce a small income stream, but are mainly designed to avoid losses.

Target retirement funds have a "target date," and companies that manage target retirement funds typically have a series of available funds, offered in five-year increments. For example, American Funds offers 11 different target retirement funds with target dates ranging from 2010 for people who are already retired, to 2060 for people just now entering the workforce.

The funds start out with most of their allocation in stocks, and remain that way for several decades in order to take advantage of the growth potential of the stock market. Over time, they gradually shift their assets to bond funds, or even into money market funds or other cash equivalents in order to reduce volatility, preserve capital, and create income as clients approach retirement.

Examples of target retirement funds

To illustrate this, let's take a look at two target retirement funds on opposite ends of the time spectrum.

First, the Vanguard Target Retirement 2020 Fund (NASDAQMUTFUND: VTWNX) is designed for people planning to retire between 2018 and 2022. As of this writing, the fund has approximately 58% of its assets in stocks, and the other 42% in bonds. Instead of choosing investments, the fund simply invests in other Vanguard index funds, making rebalancing over time much easier. For example, as retirement approaches, the fund's managers will gradually sell some of its stock-based fund holdings and buy more of its bond funds.

For all of Vanguard's target retirement funds, the ultimate goal is to reach a mix of 30% stocks and 70% bonds seven years after the target date is reached (2027 in this case). So, over the next 11 years, the stock allocation will decline by about 28 percentage points.

For a longer-dated example, the Vanguard Target Retirement 2055 Fund (NASDAQMUTFUND: VFFVX) is intended for workers who are about 40 years away from retirement, and therefore is more focused on aggressive growth than preserving capital. In fact, the fund currently has a 90% stock/10% bond allocation, which it will keep for about the next 15 years, based on Vanguard's other target funds' current allocations. After that time, the allocation will gradually shift toward bonds until it reaches a 30% stock allocation in 2062.

Pros and cons

Target retirement funds are certainly a low-maintenance approach to retirement, which can be a big positive for people who don't understand their retirement plan well, or don't want to worry about changing their asset allocation over time. And, for investors without the time or desire to play a more active role in their retirement planning, target retirement funds can be a good option.

On the downside, since different firms manage their target funds differently, there is no index on which to judge their performance. For example, an S&P 500 index fund can be compared to the S&P 500 -- no similar comparison exists with target retirement funds.

Also, target retirement funds don't take individuals' risk tolerance and objectives into account. For example, the 2020 fund I mentioned earlier is already 42% bond-based, even though its target clientele is still nearly five years from retirement. Many investors would prefer to maintain more of a stock allocation at that point.

As a final thought, it's important to be aware of the fees associated with target retirement funds. Some, like those offered by Vanguard and TIAA-CREF, just to name a couple, offer low fees that are comparable to what you would expect with standard funds. In Vanguard's case, the only fees are those passed through from the underlying stock and bond funds.

However, Morningstar found that the average target retirement fund came with an expense ratio of 0.91% -- a bit on the high end. So, before choosing a target retirement fund, compare it to some of your other investment options.

Pros

Cons

Low maintenance

No index to compare

Automatic risk adjustment over time

Generic – not meant for individual needs

Good for inexperienced investors

Some have excessive fees

Are target retirement funds right for you?

I'm strongly in favor of selecting individual stocks and funds to invest in, as I believe it is the best way to maximize your retirement account's potential. And, in the interest of full disclosure, if you look at a list of my portfolio's holdings (available here), you won't find a target retirement fund anywhere. Then again, I have the time and desire to research investments and allocate my retirement savings appropriately. Having said that, if you don't want to worry about asset allocation and maintaining your retirement portfolio over time, there is absolutely nothing wrong with selecting a low-cost target retirement fund.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.