Is a Single Target Retirement Fund Really OK?

Target retirement funds (aka target date funds) are meant to be a one-fund solution to investing. Many investors, however, are somewhat reluctant to put everything in a single fund. It just doesn’t feel diversified.

I would argue, however, that if you can find a target retirement fund with an asset allocation and “glide path” (projected asset allocation over time) appropriate for your level of risk tolerance, it can be perfectly OK to use that fund for your entire portfolio.

Important note: Do not pick a target date fund based on the date in the name. Pick based on the fund’s asset allocation. You may find that the fund that best fits your own tolerance for risk is the one typically intended for investors retiring 10 or 15 years earlier or later than you.

Vanguard’s target retirement funds* are portfolios comprised of Vanguard Total Stock Market Index Fund, Vanguard Total International Stock Index Fund, Vanguard Total Bond Market Index Fund, a small money market holding, and (in the most conservative of the target funds) Vanguard Inflation-Protected Securities Fund.

According to Vanguard’s site, as of 3/31/2011:

• Vanguard Total Stock Market includes 3,380 stocks,
• Vanguard Total International includes 6,517 stocks, and
• Vanguard Total Bond Market includes 4,907 different bonds.

In other words, with just one target retirement fund, you can achieve an extreme level of diversification–almost 10,000 stocks (spread across several different countries), plus a diversified portfolio of bonds. In my opinion, that’s as diversified as anyone needs to be.

Target Retirement Fund Drawbacks

Of course, target date funds have their drawbacks too.

First, if your portfolio is large enough, you could achieve slightly lower expenses by using individual funds–Vanguard Admiral shares or ETFs, or Fidelity Spartan funds, for example.

Second, for investors in taxable accounts, target date funds could be less tax-efficient than a portfolio created of separate funds. For example, an investor in a high tax bracket could benefit from using tax-exempt municipal bonds rather than the taxable bonds included in a target retirement fund.

Finally, there’s no guarantee that the fund company will stick to the planned glide path. That is, the current plan may be for the fund to have a certain allocation 15 years from now, but the fund company can change that plan at any time. The result: An investor who is a little too oblivious could end up with a different allocation than he/she had anticipated.

Simple Yet Sophisticated

Despite the above imperfections, a single Vanguard target retirement fund (checked periodically to make sure the allocation and projected glide path are still in line with your goals) is actually a quite sophisticated portfolio for an investor in a tax-sheltered retirement account. They offer extreme diversification and automatic rebalancing, all for an expense ratio of less than 0.2%.

Not bad, if you ask me.

*Except in an employer plan, I wouldn’t use any target retirement funds other than Vanguard’s. According to Morningstar, Vanguard’s target funds cost just 0.18% per year. The next-cheapest company (Wells Fargo) charges three and a half times as much (0.63%), and it only gets worse from there.

Update: iShares also offers a line of target date ETFs that was apparently excluded from the Morningstar study. With expense ratios of 0.29%, they’re decidedly lower-cost than most of the competition, though still pricier than Vanguard.