Are Target Funds the Killer of Your 401(k)?
The 401(k) is one of the best wealth building tools used in the United States today. With the ability to invest with tax benefits, and a possible company match, the amount of wealth generated can be life changing, not just for you, but your family. However, what we see a lot of the time is people investing improperly in their 401(k)s. This is typically due to a lack of knowledge in the investment space, which makes sense, it isn’t your full-time job. So, do what is easiest, I plan on retiring around 2050, so why not put it in a 2045 retirement target fund? If this was your thought, you might be leaving a lot of money on the table.
For this exercise we’re going to need an investor. Meet John, he is 45 years old, and wants to retire at 65 or in 2043. He makes $100,000 a year and contributes 5% with a 5% employer match. In this exercise we will assume no raise or promotion, and no inflation over the next 20 years. Because of this profile, John has chosen the Vanguard Target Retirement 2045 Fund for his investment. This fund is comprised of four sectors, the total stock market in the US, the total international stock market, a US total bond fund, and an international total bond fund. Stocks are more aggressive and carry a higher risk, while bonds are less aggressive and carry less risk. This fund has an allocation of about 85% stocks, and 13% bonds with about 2% in cash. It is also weighed about 60/40 US to International funds. This setup of funds is par for the course on how these funds are set up. They typically keep a 60/40 US to International split, and the further out you get on the target fund the more weight they put in the stocks, and the closer you get to retirement, the more the fund moves into bonds. This all makes sense, be more aggressive when you are younger and can afford losses and be more conservative when you are nearing retirement. The issue we see is this is typically too conservative of a portfolio for someone with a 20-year time horizon.
When we look back to when the 2045 fund was created (January of 2004) we can compare that portfolio’s performance against a similar 60/40 US to International portfolio of the Vanguard 500 Index Admiral, and the Vanguard Global Equity Investor. The results are an increase of about 2% a year on average. If we take John’s contributions of $5000 a year and his company match of $5000, the balances as of July 31st, 2023, would be around $581,000 for the target fund, and $730,000 for the other allocation. A difference of $149,000.
But wait, wasn’t the 2045 fund more aggressive during this time? Shouldn’t we use a different fund for projecting John’s retirement? Yes, we should. And in this case, it would be the Vanguard Target Retirement 2025 Fund. The numbers for that are even more staggering, as the final balance is around $481,000 for the 2025 target fund, a difference of almost a quarter of a million dollars. If you are more interested in the numbers, you can download the PDF here to see.
Are target funds killing your portfolio? No, but there might be better ways to invest. I believe in having a stock heavy portfolio until about 5 years before retirement, then start sliding towards the bonds. By using this more aggressive style, you can possibly retire earlier than the target fund number. As always, investing is not black and white, and each situation is different. Consult your Investment Advisor Representative to make sure you are making the best decision for you and your situation. If you would like to talk about your 401(k) plan with me, use the calendar link or contact us box to get in touch. If you want to read more on how to help your 401(k) you can sign up for a free eBook titled “Take Charge of Your 401(k)” Thanks for reading!