Index Funds vs. Target-Date Funds: What's the Difference?
Index Funds vs. Target-Date Funds: An Overview
Choosing between index funds and target-date funds in a 401(k) is a common dilemma. The main factors in making this choice are how much investors know about financial markets and how much time they want to spend. Target-date funds provide easy-to-understand options that work reasonably well for most investors. With target-date funds, all investors need to know is when they want to retire. Index funds let people directly invest in different asset classes, which usually saves on fees and gives them more control over risk and returns.
Index funds mirror the performance of a stock or bond index, often at a low cost. Expense ratios are usually at or below 0.1% for U.S. stock and bond index funds, and they can be less than 0.2% for international assets. However, investors are left on their own. They must put these assets together in ways that minimize risks for a given level of expected returns. That's great, as long as you're interested in modern portfolio theory (MPT).
Target-date funds can use both managed and index funds to create portfolios that professional managers believe are appropriate for investors. As the target date approaches, managers reduce the allocation to risky assets, such as international stocks, and increase the portion of funds dedicated to less volatile assets like bonds. Most of the best target-date funds have expense ratios of less than 1%, and some even go below 0.1%. As a rule, target-date funds that invest in index funds tend to charge less.
- Index funds offer more choices and lower costs, while a target-date fund is an easy way to invest for retirement without worrying about asset allocations.
- Index funds include passively-managed exchange-traded funds (ETFs) and mutual funds that track specific indexes.
- Investors can combine index funds themselves to get performance similar to target-date funds and reduce fees in the process.
- Target-date funds are actively managed and periodically restructured to gradually reduce risk as the target retirement date approaches.
- Target-date funds can be riskier than most people expect, but they usually become less volatile than individual stock market index funds as the target date approaches.
Index funds are popular with both individual investors and financial professionals. They include exchange-traded funds (ETFs) and mutual funds that are created to track a specific index like the S&P 500, the Russell 2000, or the EAFE. Index funds offer broad exposure to the market and have low operating expenses.
Index funds span the gamut of stock and bond investment styles, both domestically and internationally. Others may track obscure indexes or exotic asset classes, such as Brazilian small-cap stocks. However, those types of index funds rarely appear in 401(k) plans.
An S&P 500 index fund, an international stock index fund, and a bond index fund provide enough variety to serve as the core of a diversified portfolio. Other helpful additions to the mix include small-cap stocks, mid-cap stocks, emerging market stocks, and perhaps real estate investment trusts (REITs). With access to these asset classes, investors can quickly build diversified portfolios for themselves using index funds and save money.
Like any other investment, there are risks involved in index funds. Moreover, any setback that affects the benchmark will be seen in the index fund. If you're looking for flexibility, you won't find it with an index fund, especially when it comes to reacting to price drops in the index's securities. You'll have to change the asset allocation yourself by investing in different index funds.
While most index funds are low cost, some come with a high price. For example, the Rydex S&P 500 Fund (RYSOX) has an expense ratio of 1.68%. That is astounding when you consider the fact that funds with identical holdings often charge less than 0.05%. High-cost index funds are a particular issue in 401(k) plans that contain mostly managed funds, so be sure to check the fees.
Target-date funds are worth considering if your company offers them. You can either invest all of a 401(k) account in the appropriate target-date fund or invest in a selection of the investments from the plan's full lineup.
The reason they're called target-date funds is that the assets are restructured at a future date to serve the investor's needs. Mutual fund companies frequently name the funds after the target years. The idea is that the investors will need the money that year, often for retirement purposes. Rather than having to choose a series of investments, an investor can choose one target-date fund to reach their retirement goals.
Target-date funds are in many 401(k) plans. However, company plans usually only offer access to target-date retirement funds from a single provider. Fidelity, Vanguard and T. Rowe Price are popular choices. All three use their own funds as the underlying investments. Other firms may offer different strategies, such as funds of exchange-traded funds (ETFs).
What seems like an appropriate level of risk to a fund manager might not fit your life. Look at target-date fund performance in 2008 and early 2020 to see if a given fund seems too risky.
Some investors are under the false impression that target-date funds always have lower risk than S&P 500 index funds. That is not necessarily true. These funds sometimes start by investing heavily in risky assets like emerging markets and small-cap stocks in an attempt to boost long-term returns. Fund managers reallocate holdings at regular intervals and reduce risk as the fund gets closer to its target date.
Target-date funds suffered significant losses again in 2020 after a similar episode in 2008. For example, the T. Rowe Price Target 2025 Fund (TRRVX) lost over 20% at one point during the 2020 market crash. That loss might seem excessive to some investors who are only five years away from retirement. Transferring a portion of assets to a government bond ETF is an easy way to reduce overall risk (and expected returns).
Actively managed mutual funds such as target-date funds have gotten a bad rap. In many cases, it is well deserved. However, not all actively managed funds are poor investment choices. For example, Vanguard's Wellington Fund combines reasonable fees with almost a century of strong performance. Many other managed funds also offer consistent returns, proven investing strategies, and sensible expense ratios. The real competition isn't between index funds and target-date funds. Instead, investors must choose to put their savings into a single target-date fund or several individual funds, which may be index funds or managed funds.
It is best to have an asset allocation in mind for those going this route. If the 401(k) plan is the only investment, then this account is the only one to consider. Many have other investment accounts, such as individual retirement accounts (IRAs), a spouse’s workplace retirement plan, or taxable investments. In that case, a 401(k) plan allocation is just one part of an overall portfolio.
When is it a bad idea to invest in target-date funds?
Target-date funds — actively managed funds with a pre-determined asset allocation that automatically shifts as an investor ages — are an easy option for the hands-off investor, and their popularity increases every year, according to a new report. But while they have many attractive features, experts advise investors to consider all of their options.
Over half of all plan participants are invested in a single target-date fund, according to Vanguard's How America Saves 2019 report, and 77% of all participants use at least one. Naturally, the percentage varies by age: A 2018 report from Fidelity found that 68% of millennials have 100% of their assets invested in a target date fund.
Vanguard anticipates that that percentage will continue to increase in the years to come. Nine in 10 plan sponsors offered a target-date fund by the end of 2018, per Vanguard's report, compared to one-third of companies a decade ago. Their rising popularity is in part due to the fact they're the default investment option for many employer retirement plans, notes Vanguard.
"Target-date funds are great for younger investors just getting started," Ryan Marshall, a New Jersey-based certified financial planner, tells CNBC Make It. "They offer broad diversification and an easy entry point for selecting investment options."
Target-date funds allow investors to use a "set it and forget it" approach that's best for younger, less sophisticated investors, especially those who only have money in tax-advantaged accounts, like a 401(k) or IRA.
But they're not ideal for everyone.
Understand the fund's "glide path"
As you get older, the most important thing to understand is your fund's "glide path."
This refers to how the fund's asset allocation — a mix of stocks, bonds and cash, for example — changes over time as you get closer to the "target date" year in the fund's name. As you near retirement, your fund "glides" from being growth-oriented to being more conservative.
If the asset allocation of your chosen year isn't in line with your personal risk tolerance, than you can invest in your own mix of funds, or pick a different target-date year. You need to reassess when you're nearing retirement, Ashley Folkes, an Arizona-based CFP, tells CNBC Make It. Be especially cautious of investing too heavily in conservative assets.
"We aren't planning for one year in retirement, but 25-30," years, says Folkes. Target-date funds "may take too much risk off the table, and you need those risk assets to outpace inflation and taxes."
Marshall adds that retirement, unlike target-date funds, is not one-size-fits-all.
"You are lumping individuals with a few hundred thousand dollars with people that may have closer to a million dollars," says Marshall. "Investors need to invest based on their long term and short term goals and not what Vanguard is saying someone retiring in 2030 or 2040 should be."
And if you have money in a brokerage account, it makes sense to consider all of your other options.
Roger Ma, a New York-based CFP, tells CNBC Make It that it comes down to whether investors prefer efficiency, or total cost and performance, or simplicity.
"The most efficient portfolio will be more complex and take more time to manage on an ongoing basis," says Ma. "On the other hand, the simplest portfolio, like a single target-date fund, will be easy to manage on an ongoing basis, but may cost more."
Don't miss: How much money Americans have in their 401(k)s at every age
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Target-Date Funds: Advantages and Disadvantages
Target-date funds are a popular choice among investors for retirement savings, but like any investment they have pros and cons that need to be considered.
Target-Date Funds: An Overview
Target retirement funds are designed to be the only investment vehicle that an investor uses to save for retirement. Also referred to as life-cycle funds or age-based funds, the concept is simple: Pick a fund, put as much as you can into the fund, then forget about it until you reach retirement age.
Of course, nothing is ever as simple as it seems. While simplicity is one of the pros of these funds, investors still need to stay on top of fees, asset allocation, and the potential risks.
- Target-date funds provide a simple way to save for retirement.
- They offer exposure to a variety of markets, active and passive management, and a selection of asset allocation.
- Despite their simplicity, investors who use target-date funds need to stay on top of asset allocation, fees, and investment risk.
Advantages of Target-Date Funds
There are two types of target-date funds from which you can choose: target date and target risk.
Simplicity of Choice
A target-date fund operates under an asset allocation formula that assumes you will retire in a certain year and adjusts its asset allocation model as it gets closer to that year. The target year is identified in the name of the fund. So, for instance, if you plan to retire in or near 2045, you would pick a fund with 2045 in its name.
With target-risk funds, you generally have three groups from which to choose. Each group is based on your risk tolerance, whether you are a conservative, aggressive, or moderate risk-taker. If you decide later that your risk tolerance has or needs to change as you get closer to retirement, you have the option of switching to a different risk level.
Who Actually Benefits From Target-Date Funds?
Something for Everyone
Target retirement funds offer something for everyone. You can find funds that feature active management, passive management, exposure to a variety of markets, and a selection of asset allocation options are all available. Investors who are comfortable designating a percentage of their retirement, then forgetting about it for 30 years may be completely comfortable with target retirement funds. In addition, investors who do not mind doing a little research might find the exact fund they are looking for in the target fund lineup.
Just because the fund says 2045 on the label does not mean that a raging bull market will start and end just in time to keep the fund at the top of its game—nor does it mean that a severe bear market will not hit in 2044 and decimate the fund's holdings.
Disadvantages of Target-Date Funds
There are several disadvantages that investors need to consider, including:
Not All Funds Are Created Equal
The first challenge with target-date funds is that all funds are not created equal. A sample of approximate holdings (as of Aug. 31, 2020) with a target date of 2045 demonstrates this point.
|Fund||Equity Proportion||Fixed Income Proportion||Equity Allocation||Fixed Income Allocation|
|Fidelity Freedom® 2045||92.9%||7.1%||51.78% U.S. Equities||6.0% Bonds|
|41.16% International Equities||1.1% Short-Term Debt & Net Other Assets|
|T. Rowe Price Retirement 2045 Fund||93.1%||7.0%||62.9% US Equities||2.3% International & High Yield Bonds|
|30.2% International Equities||3.0% Investment Grade Bonds|
|Vanguard Target Retirement 2045||91%||9.0%||55.3% Total Stock Market Index||6.0% Total Bond Market II Index|
|35.7% Total International Stock Index||3.0% Total International Bond Index|
While each of these funds claims to be a good choice for investors seeking to retire in 2045, the contents of the funds are different. Keep in mind that this proportion may vary even more over time. That variance can be of particular concern to retirees. One retiree may have enough money on hand to invest strictly in bonds and other fixed-income securities. Another, requiring both growth and income, may need an equity component to keep the portfolio on track. A fund that meets the needs of one of these investors is unlikely to meet the needs of the other.
Beyond holdings, the funds also differ in terms of investment style. For instance, depending on what you are looking for, you can find a fund that is is made up entirely of index funds. Based on algorithms, such a fund is likely to have lower fees (see below). But investors who prefer active management, with actual human beings tracking market trends and making choices would need to shop elsewhere. Finding a fund with the right date is just the beginning of the decision process.
Expenses Can Add Up
Funds also differ in terms of expenses. Since each is a fund of funds, the portfolio you buy into consists of multiple underlying mutual funds, each of which has an expense ratio. Depending on how the fund family calculates fees, those expenses can add up quickly. For instance, one fund company may charge 0.21% of assets under management while another may charge twice or even three times that amount. As such, expenses must be a point of consideration when choosing these funds.
Underlying Funds Offered By Same Company
Beyond expenses, another consideration is that each of the underlying funds in a target portfolio is offered by the same fund company. Every target fund in Vanguard's lineup has nothing but other Vanguard funds inside the portfolio. The same goes for the Fidelity and T. Rowe funds. In an era with more than a few corporate scandals on record, you are trusting all of your assets to a single fund family.
Choosing a fund is one thing, but correctly implementing your retirement savings strategy is another thing altogether.
Effect of Other Investments
Investors who have their assets in a target retirement fund need to be aware of how other retirement investments could skew their asset allocation. For example, if a target fund has an 80% stock and a 20% bond asset allocation, but the investor purchases a certificate of deposit with 10% of their retirement assets, this effectively decreases the stock allocation of the investor's overall portfolio and increases the bond allocation.
Pre-Retirement Asset Allocation
Even investors who use the funds as their sole retirement investment vehicle need to pay attention to the overall asset allocation because this allocation changes as the target date nears. Generally, funds are designed to move to a more conservative funding position to preserve assets as the investor gets closer to the target date. If retirement is fast approaching but the balance in the investor's account isn't enough to meet their retirement needs, this allocation change will leave the investor with a fund that may have no hope of providing the type of returns required to keep those retirement plans on track.
Similar concerns emerge once retirement age is reached. While many investors view these funds as being designed to provide for retirement on or around a certain date, assets can be left in the fund after retirement. Here again, the size of the nest egg may indicate that a conservative strategy is not enough to keep the bills paid and the lights on.
Last but not least, reaching retirement by the chosen date is not just a function of choosing a fund and putting all of your money into that fund, it is also about putting the right amount of money into that fund. Regardless of the chosen date, an under-funded nest egg will simply not support a financially secure retirement.
The Best Target Date Funds For Retirement
We considered several factors to identify the best target date funds, including fees, performance, asset allocation and glide path.
Studies show that fees are a good indicator of a fund’s success. The lower the fees, the more likely the fund will outperform its more expensive counterparts. That’s not to say that expenses should be our only criteria, but they are an important one.
Most of the funds in our list have expense ratios below 50 basis points, and the most expensive is 80 basis points. There are target date funds, however, that cost more than 100 basis points. We believe that the performance of these funds do not justify the cost.
While target date funds have been around since the 1990s, performance data is limited. Because mutual fund companies have made changes to their target date funds, performance data are limited to 5-year returns. Our list will likely change as 10-year returns become available over the next several years.
The asset allocation of a target date retirement fund changes over time. In 2060 funds, equities are heavily weighted as investors have 40 years until retirement. In contrast, 2020 funds typically have no more than about 50% in equities, as those retiring in 2020 begin to use fund assets for living expenses.
While we weren’t looking for one “right” allocation, we did look for equity allocations above 80% in 2060 funds. The seven funds in our list typically allocated 90% to equities, although one fund had an 85% allocation. For the 2020 funds we examined, the range of equity allocations was more varied. They ranged from a high of 60% to a low of 35%.
Based on research by William Bengen (and others) on the 4% rule, we believe a retiree should have an equity allocation of at least 50%. As the allocation falls below this level, the longevity of the portfolio decreases. In other words, the odds of a retiree running out of money during retirement goes up. Unfortunately, while some target date funds maintain a 50% equity allocation at retirement, they all fall significantly below this level as the retiree ages.
Glide path describes how the asset allocation of a target date fund changes over time. There are “to” and “through” glide paths. With a “to” glide path, the allocation does not change once the fund reaches its designated year. For example, a 2020 fund’s asset allocation wouldn’t change in 2021, 2022, or even 2040.
In contrast, a “through” glide path continues to alter the asset allocation of a fund after its designated year. All of the funds in our list use a “through” glide path. For some, the changes in asset allocation stop after about five to seven years. For others, the changes continue for decades.
While we are agnostic on the “to” versus “through” debate, the same is not true for the stock to bond allocation. In all target date funds we examined, the equity allocations fall far below the 50% mark. As such, those using target date funds should carefully consider whether these funds best meet their needs in retirement.
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Fund giant Vanguard this week said it will merge more than $660 billion of its Target Date Retirement funds, which are ubiquitous and popular in 401(k) plans.
Chairman Mortimer “Tim” Buckley said Vanguard will save investors $190 million in fees, or about 0.03% of assets, with the move. Vanguard currently manages $8.3 trillion in investor money across all its funds.
Some criticized the consolidation, saying that “Vanguard could have saved investors money years ago” with the same consolidation of share classes, said Dan Wiener, editor of the Independent Adviser for Vanguard Investors newsletter, which tracks the performance of Vanguard funds. “I’m all for saving investors money, but Vanguard had the ability to do so many, many years ago and they didn’t.”
But other experts said target date funds across the industry have helped Americans invest in the stock and bond markets at lower costs. Today, both Target Date 2030 funds hold about $59 billion in institutional shares and $39 billion of investor shares in total assets.
“The argument about ‘why not sooner?’ is splitting hairs,” said Michael Finke, a professor of wealth management at American College of Financial Services in King of Prussia.
“Compared to the year 2000, the quality of investment portfolios is far higher and costs far lower” overall, Finke said.
Vanguard’s average expense ratio for target date funds is 0.12%, while the industry average expense ratio for comparable target-date funds is 0.37%, he said, citing Investment Company Institute data.
“We are in a much better place today than before target date funds. Workplace retirement plan sponsors have an incentive to offer low-cost target date funds. They might get sued if costs are too high,” he added. “Investors are comparatively getting an amazing deal with target date funds.”
Take Vanguard’s Target Retirement 2030 fund. The institutional class of shares charges a 0.09% expense ratio, because within the fund, Vanguard uses lower-cost share classes in the portfolio. Vanguard’s Total Stock Market Index Fund Institutional shares, for example, cost 0.03%.
The mom-and-pop version — investor shares — of Target Retirement 2030 cost 0.14%. Many of the underlying share classes are also the more expensive investor shares. The Total Stock Market Index Fund investors shares, which the fund holds, also cost 0.14%.
Finke notes that the price cut is another salvo in the fee war among Vanguard, Fidelity, and Schwab and other leading investment firms. “Vanguard has about 60% of the target date fund market,” he said.
So why the merger now? Vanguard may be having trouble lowering costs further, Wiener said.
It may also be a way for Vanguard to stand out to employers deciding which funds to use in their retirement plans.
As fees begin to approach zero, Vanguard now has to compete on customer service and the “user experience” on its website and trading apps, said Michael Foy, J.D. Power’s head of Wealth Intelligence, based in New York.
“The race to zero for trading fees is over. We’re almost at the finish line,” Foy said. “You’ve got to differentiate on customer experience. Vanguard in the past struggled with customer service, such as people having to wait hours to talk to someone.”
The solution is the better online experience, he said.
“If you provide someone with easy access to information, they won’t have to pick up the phone. It’s a lot cheaper to address investor needs through the app or the website, than pay a customer service rep,” Foy said.
J.D. Power’s most recent digital experience survey ranked Charles Schwab No. 1 for a slick, helpful experience on its website and trading apps. Schwab ranks highest in retirement plan digital satisfaction with a score of 725 out of 1,000 possible points. Bank of America (formerly Merrill) ranked second with a score of 703, and AIG Retirement Services ranks third with a score of 699.
Fidelity came in No. 5 and Vanguard No. 13 out of eighteen firms.
Fidelity said it’s taken heed of investors accustomed to a seamless online experience — not just with banking apps such as Venmo and Paypal — but with consumer favorites Uber and DoorDash.
“The way younger investors demand we engage with them as a result of the pandemic isn’t going to stop now,” said Kelly Lannan, vice president of young investors at Fidelity.
One outcome of the pandemic was “young people paid attention to their finances a lot more,” Lannan said.
Fidelity took feedback from consumer sites such as Reddit and changed its trading apps after this year’s GameStop and Robin Hood controversy over the stocks skyrocketing without any apparent cause.
“A lot of individual investors, many younger, said on Reddit that our education and data were very sound, but the user interface felt outdated. We no longer get compared to other finance sites, but to every shopping app” such as Amazon, Lannan said. “That’s the standard to which they hold us.”
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The coronavirus crisis saw extreme whipsawing in the market with the fear and chaotic climate of the spring of 2020 providing a challenge to long-term investors, daring them to stay the course.
But according to this year's edition of "How America Saves," Vanguard's insights show that many of the new retirement saving measures helped ward off rash – and potentially expensive – decisions.
Vanguard said that over the last 15 years the increased adoption of target-date funds has led to a 75% decrease in “extreme equity allocations” in target-date funds.
That’s because these funds, which provide a diversified mix of stocks and bonds that automatically rebalances over time, are meant to be left alone until they reach their so-called target date. According to Vanguard, 96% of participants who had a target-date fund in their retirement account didn't make a single trade in 2020 in those accounts.
Many employer 401(k) plans now default employees into target date funds. Interestingly, this move has coincided with a phasing out of investing in company stock through 401(k)s, which was not uncommon for many years. In the past decade, the percentage of people who invested at least 20% of their account in company stock (where it was available) fell from 30% to just 12%, according to Vanguard. Many companies don’t even offer a stock option anymore, electing for funds only.
Besides having a 401(k) default into a target date fund, an even bigger key tool that’s seen widespread adoption across companies is a default contribution (again, usually into a target-date). Vanguard says automated enrollments result in employees saving 50% more per pay period. More than half – 57% – of Vanguard's plans default workers into contributing 4% of their paychecks to a 401(k). (The average deferral is about 7%.)
The third change in defaults/automation is annual automatic increases in contribution amounts. These have resulted in balances 20%-30% greater after three years compared to those at companies without defaults in place. Around two-thirds of Vanguard’s plans with auto enrollments have these increases.
Although workers automatically enrolled can opt out of the 401(k) plan at any time, few choose to do so. According to a classic research paper on default 401(k) enrollment, participation rates at all three companies that were studied exceeded 85%, regardless of how long the employee worked there. Before automatic enrollment began, 401(k) participation rates ranged from 26%-43% after six months of tenure at the three firms and 57%-69% after three years.
Vanguard has 4.7 million people with “defined contribution plans” like 401(k)s, but the U.S. now has over 100 million people using plans like these, with many of these similar behavioral tools that Vanguard offers. However, it is the companies that decide how to structure their own plans, so much of these decisions come down to employers, given the fact that employees often don’t bother to do much with their accounts. With these takeaways, it’s likely the trends could shift even further to support automation and defaults.
Ethan Wolff-Mann is a writer at Yahoo Finance focusing on consumer issues, personal finance, retail, airlines, and more. Follow him on Twitter @ewolffmann.
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