In Part 1 of this mini-series, we covered target date fund basics and learned why these funds are an incredibly powerful tool for your retirement goals. Here in Part 2, discover 3 advanced strategies that savvy investors use to incorporate target date funds more creatively in their financial plans.
Introduction
We’ve established that target date funds can serve as key foundational pillars of almost anyone’s financial plan. These funds have democratized the investing world, providing everyday investors with an elegantly simple solution.
Before these funds were created, individual investors were forced to tinker, reallocate, and rebalance as they aged. This meticulous process was necessary if an investor wanted to ensure their portfolio evolved when their risk profile shifted.
Once these individuals had accumulated enough assets, many would throw in the towel and outsource the process by hiring a professional advisor. It’s not necessarily a bad move, but it tends to be a pricey proposition. Advisors often charge 1-2% of an individual’s assets under management which can put a material drag wealth creation. Remember, investment fees are one of the 5 hidden “parasites” slowly eating away at your financial dreams
With the advent of target date funds, the game has changed.
By pressing a single button, and purchasing a target date fund, investors gain access to an automated solution that will handle all of this complexity. It’s innovation in personal finance at its finest. But we covered most of this already.
Today, we’re diving deeper. Let’s explore three advanced ways to use target date funds for more custom applications in your personal finance journey.
Modified Basic Target Date Fund Strategy
We discussed the nitty-gritty of selecting a target date fund in Part 1. Recall, each fund has a number listed in its name. For instance, the Vanguard Target Retirement 2065 Fund.
When using a target date fund conventionally, an investor simply selects the version of the fund that corresponds most closely to the year they anticipate retiring.
But employing this selection methodology is not a requirement. An alternative way to think about target date funds as an asset class is on a risk / return spectrum. A direct correlation exists between the year in a fund’s name and that fund’s projected risk / return profile.
In other words, the higher the year listed in a target date fund’s name, the greater the return that fund is expected to generate. Importantly, that expected return comes paired with greater risk.
Recognizing this phenomenon, investors can strategically choose target date funds that differ from their actual retirement date. Thus, creating a portfolio that more closely agrees with their personal risk appetite. This enhances a target date fund’s customization and flexibility to suit individual investor needs.
Illustrative Example
Consider the following scenario:
- Joe is a 50 year old firefighter
- He has satisfied all of the requirements to qualify for his pension plan
- The plan will pay 50% of his salary for the rest of his life upon retirement
- He plans to retire in 5 years at 55
Under a standard approach, Joe would simply invest in a fund that carried a target retirement date about 5 years in the future.
The problem? This type of short duration target date fund will hold a very conservative allocation of fixed income investments like bonds and treasuries. As a result, there will be less exposure to high-growth assets like index funds.
Since Joe will receive a guaranteed 50% of his salary annually, he can likely take more risk than the average retiree. But the target date fund has no way of knowing this.
But Joe can hack the system.
He can contribute to a target date fund set for 30 or 40 years later than the day he actually plans to retire. This allows him to enjoy the benefits of the fund’s simplicity and automation while providing a solution that more closely aligns with his true risk appetite.
And the same strategy can be applied in reverse. If an investor wants to take less risk than their retirement date would imply, they can simply choose a fund with a shorter term horizon.
Building a “Tilted” Portfolio with Target Date Funds
Another way that investors can use target date funds to create a more bespoke solution is through portfolio tilting.
This Two Funds for Life strategy developed by Paul Merriman and Chris Pederson represents one of my favorite examples. They recommend the following strategy:
Multiply your age by 1.5x. The resulting figure is the percentage you put into a target date fund. Then, place the remainder of your investment portfolio in an all-equity fund.
To illustrate, a 30 year old would place 45% (30*1.5) into a target date fund, and the remaining 55% of investable assets in an all-equity index such as VTI. In fact, Merriman and Pederson recommend shooting for an even greater return by investing in an index that tracks “small-cap value” equity stocks. These types of investments have historically outperformed the broader stock market over the long term, but they come with increased short-term volatility and risk.
This portfolio tilting plan again allows investors to enjoy the best of both worlds. They benefit from the simplicity offered by target date funds while creating a plan more tailored to individual goals.
The best part? This is simply one tilting approach among an almost infinite universe of options. If you want to tilt your investments more heavily towards real estate, foreign countries, cryptocurrency, commodities, or virtually anything, the same framework applies:
Invest some percentage of assets in the target date fund, and the balance in a desired focus area.
Simple, yet powerful.
Goal-Specific Saving with Target Date Funds
The third and final alternative way to use a target date fund is perhaps my favorite application. It helps to answer one of the questions I hear most often:
“How do I approach saving for large future expenses with intermediate time horizons?”
For example, saving for a house, car, college tuition, etc. For the purposes of this exercise, let’s define an intermediate time horizon as 3-10 years.
I love the question. It’s one that I wrestle with myself.
On one hand, it’s a short enough period that investors can’t rely on the market to work its magic and deliver long term average growth of 7-10%. From an equity investing perspective, a decade represents blip on the radar. It’s near-impossible to predict market performance on this sort of timescale. Only when considering multi-decade periods can investors begin making more reasonable assumptions about potential returns.
On the other hand, the 3-10 year horizon is long enough that many would rather not park these funds in a savings account earning a paltry sub-1% interest rate. While this might suffice for an emergency fund, it’s difficult to watch larger pools of capital sit idly for years.
The Solution
So what’s the savvy investor to do?
One possibility is to use a target date fund that aligns with a specific saving goal’s time horizon. For example, if an individual plans to buy a house in the next 5-10 years, they might invest in the Vanguard Target Retirement 2025 Fund.
The healthy portion of fixed income investments in this fund will help to prevent this person’s housing dreams from being destroyed in the next economic downturn. At the same time, the fund features enough exposure to stocks that the investor can capture some upside if the market booms.
It’s a balanced approach that provides a simple yet novel solution to an age-old personal finance struggle.
Cautionary Note
This strategy is not perfect. There is significantly more risk associated with this approach than simply sticking your money in a bank account or CD.
While the more conservative nature of the fixed income assets will protect your investments to some extent, significant losses are possible.
I personally only consider this strategy for 8-10 year goals. With anything shorter, I can’t justify the risk, but this is a fundamental decision you must make for yourself.