Are target date funds really the best way to go?

In yesterday’s article, I discussed Professor Pollack’s financial advice; he suggested that everything you need to know about investing fits on one index card. Essentially, I agree with Professor Pollack; most people should try to invest as much as they can, and invest in low cost index funds. I’ll add a suggestion that you should start investing as early as you can to allow the magic of compounding to aid your investments.

Professor Pollack suggested that target funds, like Vanguard’s target funds are the way to go. I can’t say that I wholeheartedly agree with this suggestion. If you are completely unwilling to monitor your investments, these funds serve a purpose, as they will update your investment allocations and adjust them for you. I’m not crazy about allocation levels in these target funds; early on, the allocation is heavily weighted towards stocks, but that allocation dramatically changes as you age.  Here’s the allocation for several of Vanguard’s target funds:

 Fund Stock Bond
Vanguard 2060 90% 10%
Vanguard 2050 90% 10%
Vanguard 2040 89% 11%
Vanguard 2030 74% 26%
Vanguard 2020 59% 41%
Vanguard 2015 48% 52%
Vanguard 2010 34% 66%
Vanguard Retirement 30% 70%

The Vanguard 2060 Target fund has a 90/10 stock to bond allocation. This fund is geared toward people who are expecting to retire in 2060, when they turn 65 (those people born in 1995). The rationale for a 90/10 allocation is that those people are young and can more easily weather market fluctuations than older people can. If the market tanks… um, corrects, these young people will have many years ahead of them for the market to rebound. Common wisdom suggests that the older you are, the more of your investments should be in bonds — theoretically less volatile investment vehicles than stocks.

As people get closer to retirement age, they are not expected to migrate their investments to other funds, these target funds will adjust the allocation of heavily weighting of stocks to heavier weighting in bonds. As you can see in the table above, those people who are closer to their retirement age are given an ever increasing weighting towards binds. Those people who are already in retirement may have as much as 70% of their money in binds.

There’s logic here. Imagine if you retired in 2007, just before the financial and housing collapse in 2008 and 2009. The S&P 500 index declined be about 37%, If the vast majority of your money was in stocks, the value of your nest egg would have been cut by about a third. That’s tough to accept when you need to live on that money another decade or four.

By having the majority of your money in bonds, the stock market declines are easier to absorb. However, having most of your money in bonds means that you missed the huge upswing the stock market had over the past six years.

Clearly Vanguard believes having the majority of your money in bonds when you retire is the right thing to do. Why? It’s perceived to be safer; easier to withstand market declines. But you might need that money to last decades. How much can you safely withdraw each year? Convention wisdom has indicated that you can safely withdraw 4% of your holdings each year and have a high probability of having the money last your lifetime. However, as the following video suggests, having 75% of your money OUT of the stock market (and invested in bonds instead) dramatically lowers the likelihood that your money will last you entire life.

By keeping at least half of your money in stocks — even during retirement — INCREASES your chances of never running out of money…  provided that a 4% annual withdrawal rate is adequate for your needs.

Here’s a quick example of the 4% rule. Let’s say you are 65 years old and have amassed $800,000. You need to make sure that you can live on the proceeds. If you had all of that money in cash, you would be able to withdraw $32,000 the first year. Most people need more money than that each year mainly because they have real estate (rent or mortgage) expenses. I strongly suggest paying off your home prior to retirement to minimize your expenses.

After the first year, you would have $768,000 left. If you had the money in cash (without any interest or appreciation in value via investments), you could only take out $30,720 (4% of the remaining balance). Due to inflation, goods and services will likely increase each year, and the money you need to live on will be declining each year, both in actual dollars and in purchasing power. You need to keep investing during retirement. Your money needs to keep growing because (a) the cost of goods and services will keep increasing (b) if all your money was in cash (or low return bonds) you are likely to deplete your funds quickly as you need to dip into your portfolio beyond the 4% limitations to make ends meets and (c) because you don’t know how long you are going to live.

While target funds may have their place, I suggest that most people ought to invest their money in index funds, adjust their asset allocation roughly once a year, and when they reach retirement, continue investing at least 50% of their money in the stock market.

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