Is a Target Date Fund Really the Best Choice for You ?

Many investors have chose a one fund fits all choice for their retirement savings: a target date fund. In fact they are the default choice for many 401k plans.

These funds contain a mix of a globally diversified index fund and a bond index fund. But a closer look at these funds particularly in a period of rising rates may show that "autopilot" may not be the right choice.

Take for example the Vanguard target retirement 2030 fund. According to Vanguard:

Vanguard Target Retirement Funds offer a diversified portfolio within a single fund that adjusts its underlying asset mix over time. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund. Investors in the funds should be able to tolerate the risks that come from the volatility of the stock and bond markets. The 2030 fund invests in 4 Vanguard index funds, holding approximately 75% of assets in stocks and 25% in bonds. You may wish to consider this fund if you’re planning to retire between 2028 and 2032

Here is a one month chart of the fund vs the vanguard S+P 500 index fund (VFINX)
through Feb 5 

charts via bloomberg

And here is a description of the target 2020 fund


Vanguard Target Retirement Funds offer a diversified portfolio within a single fund that adjusts its underlying asset mix over time. The funds provide broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as each fund’s target retirement date approaches. The funds continue to adjust for approximately seven years after that date until their allocations match that of the Target Retirement Income Fund. Investors in the funds should be able to tolerate the risks that come from the volatility of the stock and bond markets. The 2020 fund invests in 5 Vanguard index funds, holding approximately 55% of assets in stocks and 45% in bonds. You may wish to consider this fund if you’re planning to retire between 2018 and 2022.

and a chart.vs the vanguard S+P 500 index fund (VFINX) one month through Feb.5

These funds are performing virtually identically to a portfolio that would be 100% S+P 500 yet they are designed--or investors expect-- that they will be less volatile and perform better in a sharp stock market downturn than an all stock asset allocation.

So what's going on ? The bond allocation in these funds is composed of a single index fund: the Vanguard aggregate bond index fund. That fund is a mix of bonds and has a duration of 6.1 which means that the value of the index will fall 6% when interest rates rise by 1%. That number represents total return (price change +interest earned) Clearly with the current rise in interest rates and an expectation continuation that this will continue the bond part of this portfolio and thus the fund could have some unpleasant returns.

The achilles heel of these funds is that although they reduce the exposure to the stock market in the overall stock/bond allocation of the fund to make it less subject to stock market risk...it does not make any adjustments to reduce volatility within the bond holdings of the fund.

How could such a risk reduction be accomplished ? Even using the basic stock/bond allocation of the fund the level of risk in the bond market part of the allocation could be reduced by shortening the duration of the bond allocation either by adding to or replacing the current holding with a short term bond fund. One example might be the Vanguard Short Term Bond Index Fund (VBISX) which has a duration of 2.7 years. Other funds or ETFs could further modify the overall duration of the bond allocation,

Another strategy might be a "ladder of individual CDs or bonds extending over several years.An alternative to that option would be the use of bulletshares ETFs which would give a diversified portfolio within each maturity,