Are Vanguard's Target Retirement Funds on Target?

Target-retirement funds have been in investors' cross hairs recently.

Many of the funds that have been designed to be all-in-one funds for investors with no appetite or aptitude for building and monitoring retirement portfolios have suffered staggering losses in the bear market. Some target-date funds, so called because their allocations to stocks, bonds, and other asset classes get more conservative as they approach a predetermined year, have shed as much as half of their values in the past year.

This wasn't what many target-date investors expected. They were told these were one-decision funds that would ferry their nest eggs through the financial markets' shoals to the shores of retirement and beyond. Many target-date funds have left investors, including some in or near their golden years, underwater and wondering what happened.

To their credit, Vanguard's Target Retirement Funds have suffered less than most of their rivals. But is that enough? Will losing less than the majority of the other guys in a horrific bear market be consistent with these funds' goals? Even the most conservative Vanguard Target Retirement Funds, the 2005 and 2010 funds, lost nearly 17% and 22%, respectively, from when the bear market started in October 2007 through the end of February 2009. That could crimp retirees' lifestyles. Indeed, the 2005 and 2010 funds lost more than some older, straightforward conservative-allocation funds, such as  Vanguard Wellesley Income (VWINX). Was the promise of target-date funds oversold?

To get some answers, I spoke with Stephen P. Utkus, the head of the Vanguard Center for Retirement Research. An edited transcript follows.

Q: Target-date funds in general, including Vanguard's Target Retirement Funds, suffered steep losses in 2008. Will that hinder or reverse their growth?

A: We've had this very large market shock, but I think most (plan sponsors) realize stock prices periodically can lose 50% of their value. This kind of shock is unfortunate, and it's painful, but it's not out of the realm of expectations. Everyone's upset about falling asset prices, but at the same time that doesn't change the fundamental investment rationale: that people should hold broadly diversified portfolios for longer-term goals. I think that will tend to trump the concerns about short-term market volatility.

Q: Vanguard Target Retirement 2010, which is for retired or almost-retired investors, lost 21% in 2008. Is that too risky?

A: When we structured these funds, we didn't just look at expected returns and statistical measures like the variance of the portfolios. We also looked at worst-case outcomes based on historic periods and then we looked at what would happen if there was a three or four standard deviation event. The committee that structures our portfolios thought both about the longer-term need for growth in savings throughout retirement, as well as worse-case outcomes. Obviously 2008 was a substantial shock, but it was not outside one of those worse-case outcomes that we looked at.

Q: How can investors who have sustained deep losses get back on track toward their goals?

A: You can either scale back how much you're going to spend because your portfolio, in the case of the 2010 fund, is down 20%-21%. Alternatively, you could extend your work career, if you have that flexibility. The interesting thing about this, though, is that it's not unique to target-date funds. If you look at our study, when you get toward the later ages, the typical 401(k) participant not using a target-date fund on average has 60-some percent of his or her assets in equities just before retirement. So, the issues you raise are not unique to target-date funds. They are unique to people holding risky portfolios because they want to achieve higher returns in the long run.

Q: In 2006, Vanguard added more equity exposure to its Target Retirement Funds, including bigger helpings of international and emerging-markets stocks. The argument then, with which Morningstar agreed, was that the risk of running out of money in the long run was more serious than that of shorter-term volatility. In the light of recent volatility, was that thinking wrong? Does Vanguard have any regrets about the changes?

A: Not given our asset allocation. I would agree with you that some others may have overplayed it. But we did look at worst-case scenarios because, as fiduciaries, what we thought was, "We're putting ourselves in the place of a relatively unsophisticated person who doesn't want to make portfolio-construction decisions." So, when you're down 21% percent, we can look you in the eye and say, "In order to pursue your longer-term investment goals, losing 20% in extreme, extreme market conditions is just part of the costs of pursuing those goals."

Q: When you mix other funds with target-date funds, do you increase the risk of needless duplication and mediocre results in your portfolio?

A: There really are two types of target-date investors. A person who has all of his or her retirement wealth in Target Retirement 2010 is just half the world. The other half includes people who mix and match with other things. The big questions going forward are how many people do that because they have a really rational reason? How many people are doing it just because they don't know what a target-date fund is?

Q: Is there an ideal way to use target-date funds?

A: There are going to be participants who in a voluntary choice setting are going to be mixed investors. Unless you have a very rational sophisticated reason for doing what you are doing, though, you're probably better off being a pure (target-date) investor.

My Take
What do you do when the market savages even well-considered asset-allocation plans, forcing savers and retirees to spend less, work longer, and save more? In this case, the answer is not to ditch the funds. It is to spend less, work longer, and save more. Vanguard's Target Retirement Funds are still Morningstar Analyst Picks for their low costs, transparency, diversification, index fund focus, and reasonable asset-allocation plans. They should serve investors well over the long term. Investors have learned the hard way, though, that no matter how carefully crafted your asset allocation, you can't rely on fickle market returns alone to build retirement nest eggs.

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