RetireMentors: How to create your own target-date retirement fund

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Create a target-date retirement fund? Really?

Why in the devil would anybody want to reinvent the wheel, so to speak, when most big mutual-fund companies already have well-run funds available at reasonable cost?

It’s a good question, and I can think of several answers that might make this an attractive idea. They all boil down to the same idea: You might make more money if you do it yourself.

(In addition, some people just like to tinker and build things themselves. How else to explain the widespread popularity of kits that allow you to pay more and invest lots of time in making everything from potholders to dinners to radios to sailboats?)

In the case of a target-date fund, I think you can actually save money — or make a whole lot more of it — if you’re willing to invest the time.

Vanguard’s target-date retirement funds levy annual expenses of 0.13% 0.15%

In an article I wrote last year, I showed that a regular modest investment plan (starting at $1,000 a year in 1970 and increasing by 3% each year thereafter) in the S&P 500 index SPX, +0.48%  could grow to $1.88 million over 48 years, assuming a 0.1% annual expense ratio for an index fund.

Without the 0.1% expense, the final total would have been $1.95 million. The difference, about $70,000, would buy a lot of fancy dinners in retirement. And if you invested $5,000 a year instead of $1,000, the difference would let you buy a boat — assuming, of course, that your spouse went along with that idea.

Can you shave 0.1% off the cost of a target-date fund? I think you can.

For example, you can get an S&P 500 index fund for 0.04% instead of paying 0.15%.

There’s another way — not obvious until you look under the hood of target-date retirement funds — that I believe you could add 10 basis points (0.1%) to your returns.

A commercial mutual fund takes money in and pays money out every business day. This lets the fund essentially rebalance its portfolio (at least partially if not fully) every day.

My calculations suggest you can get an additional 0.1% of return (assuming a portfolio that’s roughly equivalent to that of a target-date fund) if you rebalance annually instead of monthly. (The difference is probably even greater when compared with daily rebalancing.)

Their glide path

I think it’s also very likely that you’ll make more money if you adopt your own glide path toward retirement.

Let me explain: Every target-date fund has a glide path that gradually moves its investments out of equities and into bonds as retirement approaches. This is a great service to shareholders.

However, even the target-date funds with the farthest-out retirement assumptions (for example a Vanguard 2065 fund VLXVX, -1.42% ) hold around 10% of their portfolio in bonds. This excessive caution is neither necessary nor helpful for young shareholders, whose greatest need is for long-term growth.

Yes, bonds protect investors from bear markets that might prompt them to bail out. But for those who start with a relatively small balance, the regular contributions all by themselves dramatically reduce any downside volatility.

It’s well known that over the long haul, equities produce significantly higher returns than bonds.

From 1929 through 2018, the average compound 40-year return of long-term U.S. government bonds was 5.4%, enough to double your money about every 13.3 years. The average compound 40-year return of the S&P 500 was 10.9%, enough to double your money about every 6.6 years.

Even if that difference is applied to only 10% of a portfolio, the results can matter — especially when modest gains in those early years are allowed to compound for decades in the future.

The glide path I’m going to suggest for your DIY target-date fund will be even more productive.

Your glide path

I suggest you adopt an all-equity portfolio until you’re 40 years old, presumably 25 years from retirement.

For the early years, I suggest you own all equities until you’re 40 years old. The long-term return of that allocation should give you an extra 0.2% compound return when compared with Vanguard’s target-date glide path, which calls for approximately 10.4% in bonds from age 35 to 40.

When you reach retirement, I suggest you consider holding 50% to 60% in equities permanently, which is more than you’ll find in Vanguard’s glide path.

This could make a big difference in what you have to spend in retirement and/or leave to your heirs.

Better diversification

The great majority of equity assets in Vanguard’s funds are invested in U.S. and international “total stock market” funds. Those are dominated in each case by large-cap blend stocks like those that make up the S&P 500.

You can do better.

Small-cap value funds over the long haul have handily outperformed the S&P 500. Yet those stocks make up only about 2% of the typical target-date fund’s equity holdings.

My suggestion: Split the equity part of your portfolio equally three ways: small-cap value, U.S. total market index, international total market index. That limits your international exposure to one-third. If you want to skip international equities altogether, go half-and-half with U.S. total market and small-cap value.

Can you actually do this?

If you have access to a 401(k) or similar retirement plan, you can.

Almost every plan gives you access to either an S&P 500 Index fund or a U.S. total market fund. These are essentially interchangeable, though you will get slightly more diversification in the total market fund than in the S&P 500 fund.

Most retirement plans offer at least one U.S. value fund; unless such a fund is described as a small-value fund, it’s probably large value.

Even though this won’t give you quite the extra punch of a small-cap value fund, based on over 90 years of historical performance, adding a large-value fund is likely to boost your long-term returns very significantly.

If you don’t want to beef up your equities with value stocks but still want to eliminate bond funds until age 40, every 401(k) plan will let you hold 70% in a U.S. total market fund and 30% in an international fund.

If you want the benefits of small-cap value stocks and your plan doesn’t have such a fund, you can open a Roth IRA and buy a small-cap fund or ETF there.

You can put as much or as little into this account as you like. In your all-equity years, I would suggest you start this IRA with about half the money that’s in your 401(k).

Finally, you can find a two-fund alternative that’s simple and effective right here.

No matter how you do it, creating your own target-date portfolio gives you more control over your exposure to risk and your potential for return.

You can learn more at my website. There you will find links to articles, a podcast, and a 50-minute video

Richard Buck contributed to this article.