When I started my 401K, I wanted to spend the least amount of time on it as possible while ensuring that I was making responsible financial decisions. Contributions to my 401K were already automatic, so I didn’t have to think about that. The next step was to avoid having to think about what I was investing in. I didn’t want to spend any time figuring out how to allocate my money between different funds. I was already busy enough with my day job and my post-tax investment portfolio which required researching individual stocks. Therefore, I resorted to using what are known as Target Retirement Funds (TRF).
TRFs are mutual funds created by blending a mix of international equities, domestic equities, and bonds. The weightings/proportions of each asset class automatically changes over time as you near retirement to gradually reduce your investment risk and increase its stability. You pick a TRF based on when you expect to be able to retire. A TRF with a retirement date way out in the future (2050, 2055) will have a much higher weighting on international and domestic equities (stocks) since those investments have a higher expected return but with more risk. A young person can have a higher appetite for risk and can take on short-term losses. On the other hand, a TRF with a nearing retirement date (2020) will have a much higher weighting on bonds since they provide more stability and predictability. Stability and predictability is especially important for someone who is about to retire since she can’t risk losing a large portion of her assets.
Since my company uses Vanguard for their 401K plans, I have access to a variety of Vanguard TRFs. If you look at the screenshot below, you’ll find the different TRFs available from them.
As you can see, the TRFs are differentiated by the retirement date (2010, 2015, 2020...2060). They are relatively low cost considering they are 70% lower than the industry average according to the Vanguard website. Although the YTD (year-to-date) and 1-year returns haven’t been all that great, the 5-year average annual returns have been better. In theory, a fund with more risky assets such as stocks as opposed to bonds should produce a higher average annual return in the long run. Therefore, the TRFs with retirement dates way out in the future should have higher 5-year and 10-year average annual returns.
Below is the composition for a 2010 fund. You’ll see that the largest holding is a bond fund, whereas the smallest holding is the international stock fund. The heavier weighting towards bonds will provide more stability for someone who is about to retire.
Below is the composition for a 2055 fund. Notice that the two larger holdings are stock funds whereas the two smaller holdings are bond funds. The high allocation towards stocks increases the potential return.
I think that TRFs are a great way to automate, diversify, and simplify your retirement planning if your employer offers a 401K plan. These funds automatically adjust their composition towards less risky assets over time. As a result, you don’t have to rebalance your holdings every year. Since Vanguard funds are generally low cost, you’ll save on a lot of investment expenses. Over time, a consistent strategy of contributing pre-tax dollars to your 401K can ensure that you have enough money to retire.
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