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Today, we have a great guest post from Owais from Simple Money Man. Enjoy the read!
Hello, I’m Owais and run the website Simple Money Man. Today I’m grateful to have the opportunity to have a spot on Mustard Seed Money. A bit about myself: I started working at the age of 15 (part-time because of high school of course) and fell into Accounting during college and Finance in Graduate school. Even though I’ve spent over 15 years working in the Accounting & Audit industry, I only realized a few years ago that I was interested in Personal Finance. With a desire to learn and share simple yet effective concepts and ideas on investing, saving and ultimately retirement, I took the plunge and created my website. I hope you enjoy the post below.
From Target Date Funds to Targeting Lower Cost Index Funds
Usually on the first day of a new job, we receive some new hire paperwork from Human Resources. Included in that package is paperwork concerning which retirement plan we’d like to participate in, how much we’d like to contribute and how to get started. Sometimes we have to go online and complete this information.
The process of going through retirement paperwork can be overwhelming to say the least. It’s because we are generally provided with a bunch of options or funds to choose from. In the end, we may just say I don’t feel like dealing with all this reading and will take the easy way out and pick a retirement fund option known as a target date fund. In recent years, more and more employers have started to offer this simple way for its employees to save for retirement.
Target date funds are mutual funds that generate an asset mix based on the anticipated date the participant is expected to retire. For example, if you are in your 20s and plan to retire in 2060, you would select a 2060 target date fund. This target date fund would be designed to be aggressive in its investment allocation. That is, it would have holdings in small-cap and growth companies and as the years go back would readjust the asset mix into more conservative assets such as bond funds and other cash equivalents. Thereby the fund “targets” the year of retirement based on its name and adjusts investments within the fund accordingly.
History of Target Date Funds
Target date funds were created in 1994. This was in response to a lack of education by participants in 401(k) plans. Many participants were just not willing to conduct their own asset allocation and because of this nervousness and lack of desire on the part of the participants, the demand for target date funds was born. They were first introduced by Wells Fargo and Barclays Global Investors. Of course in the late 90s and early 2000s other investment companies joined the trend such as Fidelity, T. Rowe Price, and Vanguard with their own target date funds.
In order to facility so many participants into these retirement plans in an efficient way, groups or clusters of funds were created. These creations were distinguished by the average years participants were expected to enter into retirement.
So for a 25-year old planning to retire at age 65, a 2060 target fund may be appropriate. For a 30-year old a 2055 fund, and 35-year old a 2050 fund may be the right choice. You get the picture. The further away you are from retirement, the more aggressive the fund’s portfolio model will be (i.e., more in stocks and less in bonds). The closer you are to retirement, the more conservative and the fund allocation will adjust by itself without you having to go in and do anything. Sounds easy right? It sure is and that is why so many people decide to enroll in them.
Target Funds Today
Target date funds continue to be super-popular these days in work retirement plans. They are easy accessible as they are offered by many employers. My previous two employers offered target date funds and yes I was enrolled in them.
Even at my current employer, I initially selected a target date fund. It allowed me to be, well quite honestly lazy with my retirement planning. This along with the fact that target dates funds are the default funds offered in most defined contribution plans. Furthermore, many employers offer automatic enrollment as well into these funds and once people are in most don’t bother changing their investments because they know the target date fund will take care of it.
And even in my very first job which offered a 401k plan, most likey I selected a target date fund because I didn’t know much about the other funds. I probably read that this fund is for people that plan to retire in year 20XX. And so I took my calculator and did a quick difference between my age and 65 or 67 and said ok, that’s the one that’s right for me, ignoring everything else and moving on to the next piece of new hire paperwork.
Target Date Funds Composition
Target date funds have within them funds. So a target date fund is basically a fund of funds. It may have some money in a large cap fund, some in a mid-cap fund, and some in a small-cap fund. It may have some money in an international fund, and some in a bond fund. Generally the underlying funds in a target fund are from the same fund family.
So for example, if you are in a Fidelity target date fund or what Fidelity calls a Freedom Fund, the underlying funds are that of Fidelity as well and you as an investor have no control of those funds. Check out the allocation below of the Fidelity Freedom Index 2050 Fund:
Target Fund May Not Be My Target
As we already know the closer someone is to retirement, the more a target fund’s objective changes to a more conservative investing approach. In sticking with the Fidelity Freedom Index 2050 Fund mentioned above, it has 26.94% in International Equity Funds. However, the Fidelity Freedom 2040 Fund has 31.13% in International Equity Funds.
If you are bullish in the international sector and are seeking more diversification and exposure there, but are comfortable with your domestic allocation, maybe you should develop your own mix of lower cost index funds and save in fees. This is what ended up doing and will discuss later.
Additionally, the set it and forget it nature of target funds is not one favored by many investment publications including Motley Fool who states that it’s important to continuously monitor the underlying fund performance to make sure its meeting your expectations in terms of risk tolerance and returns. And up until a few months ago, I started thinking, are target date funds really worth it? Should I employ a set it and forget it approach for something as big as retirement? Well maybe, but maybe not.
Target Date Fund Performance
Apart from having less flexibility in allocating with target funds, another drawback is performance. The target date fund I previously had is a fund of funds. The underlying funds are actively managed. According to CNBC, many actively managed funds are being outperformed by passive funds and ETFs. And about 85% of active large-cap funds fail to meet their benchmarks.
The article further identifies Vanguard (the biggest provider of index products) which has received $216 billion in inflows. I’ve found that it really only makes sense to own an actively managed fund if you’re looking for a particular investment and in a specific sector as illustrated by Verdan Vuk, Senior Analyst for Money Forever. Otherwise, he says you’re just wasting money.
Target Date Fund Fees
If you’re putting money into a retirement plan, you’re doing better than two-thirds of Americans because who are otherwise not. So you’re already ahead of the game anyway. But there may be a way to do better and that is by avoiding excessive fees. One of the main reasons why investors avoid target date fund is very simple: high fees. Everywhere I read this is a common theme as some fund companies can “charge twice or even three times” the amount in fees as their competitors.
The fund I was in (TRRMX or T. Rowe Price Retirement 2050 Fund) has an expense ratio of 0.76%. So I decided to take action by logging into my account and creating my own allocation. My retirement website offers an interactive tool where I can enter data such as my age, when I plan to retire, how much I plan to spend in retirement, and what I’ve saved thus far. The output results in the creation of a customized allocation. This is the allocation model that was suggested for the variables I provided:
Using this model, I proceeded to allocate my current fund and al future contributions from the target date fund into lower-cost index funds. This movement of investments is offered for free by my retirement provider and may be by yours as well! Below is my new self-created portfolio model:
Investments & Allocation |
Expense Ratio |
Asset Class |
|
Vanguard Total International Stock Index Fund – Institutional Shares – 25% |
0.090% |
Int’l |
|
Vanguard(R) Small-Cap Index Fund – Institutional Shares – 5% |
0.050% |
Small-Cap |
|
Vanguard(R) Mid-Cap Index Fund – Institutional Plus Shares – 10% |
0.010% |
Mid-Cap |
|
Vanguard(R) Institutional Index Fund – Institutional Plus Shares – 50% |
0.020% |
Large-Cap |
|
Vanguard(R) Total Bond Market Index Fund – Institutional Shares – 7% |
0.040% |
Bonds |
|
*Investment Contract Pool – 3% |
||
|
* |
||
|
Total Expense Ratio |
0.210% |
|
|
Target Fund |
0.760% |
|
|
Difference |
0.550% |
And with this change, I’ll be saving over half a percent in annual fees, as highlighted above! Trust me, over-time that can add up to a lot in fees. I did the math really quickly and when the balance gets higher the expense ratio really starts making a difference:
|
When 401k Balance Is: |
Ratio Difference |
Annual Savings |
|
$ 100,000 |
0.550% |
$ 550 |
|
$ 500,000 |
0.550% |
$ 2,750 |
|
$ 1,000,000 |
0.550% |
$ 5,500 |
|
$ 1,500,000 |
0.550% |
$ 8,250 |
So I went online a googled some more, for an expense ratio calculator. I found a simple one on Begin to Invest. Based on the below calculation, if someone were to have $200,000 as a starting point and decided to move investments, contribute the maximum as it stands right now, earn 6%, then they’d save over $280,000 over 30 years when employing a low cost index fund VA a target date fund:
I encourage everyone to use this site and plug in some hypotheticals to see what savings are available.
Take Charge or Your Investments
Retirement is a major part of our lives. And as such, planning for it should be as well. We owe it to ourselves to learn more about low cost index funds because they cost less than target funds and have performed better historically. Why pay more and get less?
Interesting post! This is the first time I’ve heard of Target Date Funds. I contribute to my retirement account through my employer. I know it’s a mix of funds, but I’m not sure I understand the details of it. Thanks for the analysis!
Ms. Frugal Asian Finance recently posted…How I Went From 0 To 31,104 Views/mo In 7 Months
I didn’t pay much attention to the investments with my employer for a long time. Only until recently I just thought I’m contributing more here than anywhere else so it makes sense for me to make sure I’m getting a good deal. I’m glad you liked it! 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
I also did a calculation of the potential fees that I can save if I manage my own investments. When I discovered that the number can be in the six figures, I was more than motivated to keep those money for myself.
When it comes to money, the philosophy is: “no one has a higher stake in your money than you, so you should at least know how to manage your own money.”
Another reason to invest your money is, “who can you really trust with your money?” I had read one too many stories of people nearing retirement and suddenly found out that their financial advisor was not working for them. The financial advisor took care of their money – literally. I don’t want to take such a risk for my own retirement. You have no time to recover if that happens.
Leo T. Ly @ isaved5k.com recently posted…10 Money-Saving DIY Home Renovation Projects
Wow; those are the kind of stories that make headlines and you don’t want to be in no way part of them. I totally agree that you as the contributor have the most at stake. Portfolio Managers can be fired and may still be able to find a job. I’m glad you found savings from your fee calculation! 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
Hello Owais, We have a lot in common. I also started working at 15, went into accounting/auditing/finance and love personal finance. Enjoyed your post. Totally agree that is better to take control of your investments with a few low cost ETFs rather than putting one’s money in a target fund. The savings in fees is dramatic over long periods. I look forward to checking out your site. Tom
Tom @ Dividends Diversify recently posted…I Have Lost My Compass (Part 1)
It’s amazing that I’ve found so many like-minded people online over the past couple of years. It’s comforting and I’m thankful to know that there are so many good resources to help us become better caretakers of our Personal Finances and share each other’s ideas. I’m glad i changed over to ETFs while I still have many years until retirement. 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
Nice post. One point I’d like to make is that you can buy a target retirement fund that is made up of index funds. For example, the Vanguard 2050 fund expense ratio is 0.16% today. I think this is still more than buying the underlying assets. However, for those that know they are going to forget to rebalance, I think it’s an adequate alternative.
Great idea! That sounds like a win-win situation. Over the past year, I’ve really become a big fan of Vanguard and their offerings. And since my employer offered their funds to select from individually, it worked out great. 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
I LOVE Vanguard!
Jason@WinningPersonalFinance recently posted…My 7 Most Regrettable Financial Decisions
Some target date funds are super low-cost still, and so the difference isn’t that stark. I like target date funds because they provide asset-class balancing and I don’t need to think about it; so long as I choose a fund that meets my desired allocations and risk tolerance. Can always pick a target date fund farther out to be a little bit more aggressive.
I think as long as target date fund fees aren’t significantly more, it’s perfectly reasonable for someone to choose them and be happy with it 🙂
Dave @ Married with Money recently posted…Paying Off $250,000 of Debt And Full Of Doubts
Absolutely! it’s all about getting more bang for your buck. The biggest reason why I switched over was due to the high fees and I think the majority of them charge higher. I think it depends on what the employer offers in their basket of investments to choose from. You definitely want to be enrolled with them especially due to the matching fund’s incentive. The ones that don’t are definitely a bargain and takes a lot of work in terms of rebalancing away from us which is great. 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
I don’t like target funds. I definitely prefer just choosing low cost index funds that try to mirror the genreal market.
It took me a while; I was procrastinating at times and thought it would be a long process involving calling my 401k provider going through paperwork. To my surprise it was pretty easy to change into other lower-cost funds 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
Great guest post. Target date funds are a good starting point for many people. They require little attention. Just keep adding money every paycheck. Just be sure that the asset allocation meets your goals and risk tolerance.
Dave recently posted…Keep Your Hands Off My 401K
Great way to describe it “starting point”. They are the default option for many employers because of the hands-off approach and various year options. 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
SMM – Very nice analysis. I also manage my own Vanguard Funds to keep expenses as low as possible, optimize taxes, and so on. I re-balance once per year.
I’ve never used a Target Date Fund, but I might consider it when I hit 70 or 75 just to simplify things for my old brain.
Mr. Freaky Frugal recently posted…How much do you REALLY need to retire?
Yes at that point it makes a whole lot of sense to switch over. The allocation would stay mostly the same to conservative investments like perhaps a diversified bond fund. I see more and more people switching over to Vanguard low-cost funds. I’ve come to known Charles Schwab offers some really low-cost ones too. 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
Oh man I’m drooling over your fund options. My 401k plan has awful choices with crazy high fees. I would freaking love to have some of those options.
I don’t have a beef with all target date funds. Vanguard 2050 fund has an expense ratio of 0.16%. That is pretty freaking good. I frequently recommend people with zero knowledge or interest to do either a target date fund from Vanguard or setup an account with Betterment. Like you said most people won’t even contribute anything much less do an hour of research to pick good funds or re-balance regularly.
Grant @ Life Prep Couple recently posted…Why I’m Not Buying The Mutual Fund of The Future
That’s pretty low for a target fund; not surprised to see it being Vanguard though 😉
Yes like you said sometimes we are forced to go with the options provided at our workplace. This is especially true if they provide a matching option. Hopefully, your work will roll out new funds to choose from!
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
Well done.
Yes, cost matters more than most of us can imagine. That reason alone is enough to avoid them.
And over time, it becomes more and more important to give cost high consideration in the selection of our funds. Thanks for stopping by 🙂
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
Excellent topic, Owais. It’s incredible how much more some companies charge to sell you a fund of funds, when the funds themselves are incredibly low cost.
I have to point out, though, that you’re not saving 0.55% per year. You’re saving about 0.70% per year. Rather than adding the expense ratios together, you need to take a weighted average, and yours will be in the range of 0.05% to 0.06%.
So the DIY option is even better than you thought.
Cheers!
-PoF
Always better to know you’re saving more than expected 🙂
Thanks for pointing out to do this the weighted-average way. The savings can continue to change over time as you reallocate, but it will still cost significantly less than a fund of funds.
SMM recently posted…From Target Date Funds To Lower Cost Index Funds
Great post! It is crazy to crunch the numbers on expense fees. Or even any funds that have load fees which hurt even more. Vanguard still does a pretty good job of having low expense fees on target funds compared to others. I still like having a set and forget, low expense fee, S&P500 index fund in my retirement accounts. Don’t have to beat the market, just have to match it and you will do well long term. Thanks for sharing.
Dividend Daze recently posted…One Year Blogiversary!
Long-term is key. Having that focus helps us stay consistent and disciplined and focused. More and more people are coming around to Vanguard and it’s really no surprise. Everyone loves a great deal 🙂
SMM recently posted…Make Personal Finance Great
It’s so crazy how little people look into the expense ratios of their investment accounts. Those can really eat into your savings. Great article!
Tyler M Jones recently posted…Not All Funds are Created Equal: How to Evaluate the Investment Options in your Retirement Savings Plan