Target date funds (TDFs) have grown in popularity as an investment of choice among 401(k) plan participants since the Pension Protection Act of 2006 included them as a qualified default investment alternative, or QDIA. A QDIA offers plan sponsors a safe harbor from liability if they use it as the default investment election for plan participants who do not make an affirmative election on their own.
A few years ago, Morningstar Inc. began including TDF families under its medalist rankings, which are modeled after the Olympic gold, silver and bronze medals. Since the inception of their TDF family rankings, only two families have achieved gold status: T. Rowe Price and Vanguard.
Let’s take a look at what makes Vanguard different and perhaps better. (See also: What Are Custom Target Date Funds?)
Vanguard is known for low mutual fund and ETF expense ratios and its TDFs are no exception. According to Morningstar, the average asset-weighted expense ratio is a low 0.17%. This is due to the fact that the underlying mutual funds used in the TDFs are all low-cost Vanguard Index funds.
A Simple Approach
Across the range of target years covered, the various TDFs use a maximum of five funds and some use less in varying percentages. The five funds are:
- Vanguard Total Bond Market Index II Inv (VTBIX)
- Vanguard Total Stock Market Index Inv (VTSMX)
- Vanguard Total International Bond Index Inv (VTIBX)
- Vanguard Short-Term Inflation-Protected Securities Inv (VTIPX)
- Vanguard Total International Stock Market Index Inv (VGTSX)
Note the TIPS fund is only used in the some of the shorter-dated funds for those in or near retirement. These funds are used in varying allocations in the 12 TDFs that range from a retirement income fund to a 2060 fund. (See also: Do Vanguard ETFs Pay Dividends?)
The five funds used by Vanguard cover the following nine asset classes:
I like Vanguard’s simple, straightforward approach, but critics might say that the lack of more funds such as a mid-cap or small-cap index fund limit the manager’s flexibility in allocating assets.
The Glide Path
The glide path of a TDF series refers to the age where the equity allocation flattens out either to or through retirement. In the case of Vanguard, the glide path kicks in around age 70. (See also: Guidance on Pairing Annuities, Target Date Funds.)
The glide path assumes that the investor will hold the fund until his or her death. This may or may not be the case, but Vanguard, does try to encourage retirement plan participants to maintain their positions in the TDFs when rolling over to an IRA (hopefully with them).
The Vanguard TDFs have consistently ranked near of in the top quartile of their respective target date peer groups over the years. As of the most recent quarter, nine of the 11 Vanguard target date funds earned the top ranking from ranking service FI 360; the other two were ranked in the top quartile of their respective target year categories. These high rankings are in part a function of Vanguard’s ultra-low-cost structure. (See also: 3 Best Vanguard Target Retirement Funds.)
The Vanguard Effect
Vanguard, as the largest of the TDF families, has tended to outperform its peers. This opinion reflects heavy exposure to U.S. stocks and the advantages of their lower fees.
Beyond this, I suspect the cachet of Vanguard with its reputation for low costs and a mix of top-notch index funds is a big draw for investors and retirement plan sponsors. (See also: How Often Do Target-Date Funds Rebalance?)
With the emphasis on keeping expenses in 401(k) plans low, choosing Vanguard’s TDFs are a solid choice for many retirement plan sponsors, though it is difficult in some cases for financial advisors who need mutual funds to generate revenue sharing to suggest Vanguard with its ultra-low expenses. (See also: Top Vanguard Funds for Retirement Diversification.)
The Bottom Line
As you might expect from Vanguard, its TDFs are low-cost, simple and straightforward. The firm uses a few of its index funds as the underlying investments, and this formula has helped propel the company into the top spot in terms of TDF assets. (See also: 3 Emerging Markets Vanguard Funds.)