Posted on 08 January 2012.
There are several ways to allocate your retirement investments. I have listed them in order of difficulty with an explanation and the management fees associated with them. (Management fees are shown as the percentage of you total account balance)
Target Retirement Funds
These are by far the easiest ways to invest for your retirement. You decide the year you are going to retire and find the right target fund. The funds are generally spaced in 5-year increments 2040, 2045, etc.
The funds are diversified based on the target year of the fund. This simply means that the fund automatically moves your investments from mainly stocks over to bonds and cash equivalents gradually over time. The company that manages your fund picks a mix of stocks and bonds that will give you the best returns with the least amount of risk. In the end, you portfolio is mainly bonds and cash equivalents.
When my wife asked me to set up her ROTH IRA, she told me not to put it in anything too risky. So, all of her money is going into a target retirement fund. Only one portfolio to view when you login to see how you account is doing. Easy, Quick, and low stress.
Target Retirement Fund Fees: Expect to pay 0.7 – 0.9%. Vanguard is the best option, their fees are around 0.22%. Picking Vanguard saves you 0.5% right of the bat.
Index Funds generally contain all or most of one particular type of investment. These investments can be the entire stock market, a mid-size company index, a small company index, an international index, an emerging market index, a government bond index, a corporate bond index, a real estate index fund and many others.
Building your retirement portfolio with index funds is a little more difficult than purchasing a single target retirement fund. This is because now you are in charge of diversifying your portfolio. The rule is the younger you are the less bonds you own, the older the more bonds you own. To determine what percentage of your portfolio needs to be stocks, I have seen many different “rules.” The older rule I have seen is 100 minus your age. I have seen this go as high as 130 minus your age. For the older rule: If you are 32 then 100-32 = 68% of your holding should be stocks. To me this is too conservative. I use 120 minus my age. The most important thing is to stay within your own risk tolerances.
It is possible to have a completely diversified portfolio using as little as 3 to 5 index funds; however, you must make sure that you are very well diversified. To do this, I suggest making the Total Stock Market index your core investment. After that, do some research on funds and diversify.
Index Fund Management Fees: I would not pay more than 0.3% on any index fund. Some funds are as low as 0.09%
For retirement planning purposes, you use the same type of strategy as with index funds. The difference here is that mutual funds are already diversified somewhat, so it makes hitting your allocation target more difficult. Mutual funds also cause tax problems if they are not in a ROTH IRA and a 401k due to the fund managers buying and selling all year.
Finally, the biggest problem with Mutual funds is that the average management fee is 1.5%. It is possible to build a diversified portfolio using funds that have fees of 0.5% – 0.9%, but that is going take much more research. It is going to take much longer because you need a minimum of 12 mutual funds in your portfolio to diversify properly.
Mutual Fund Management Fees: These can range from 0.5% to over 2.0%
Invest in a Target Retirement Fund if you want to save for your retirement but do want to stress over allocations and rebalancing. Use a Vanguard fund to keep the maximum amount of your money.
If you are the more adventurous type that wants to put in a little or a lot of research, go with index funds or mutual funds. Just remember to keep the management fees as low as possible and diversify.