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Target date funds are everywhere for American retirees, advertised as an easy one-stop shop. And in some cases, that
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might be true. But recent research shows that the average target date fund is much worse than you might think. So,
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we'll break down all the details today and share with you how to judge whether
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your own target date fund is good, bad, or outright ugly. Welcome to personal finance for long-term investors, where
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we believe Benjamin Franklin's advice that an investment in knowledge pays the
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best interest both in finances and in your life. Every episode teaches you personal finance and long-term investing
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in simple terms. Now, here's your host, Jesse Kramer. Welcome to Personal Finance for Long-Term Investors, episode
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137. My name is Jesse Kramer. By day, I work at a fiduciary wealth management firm helping clients nationwide. You can
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learn more at bestinterest.blog. blog/work. The link is in the show notes. By night, I write the best
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interest blog and I host this podcast. I also put out a weekly email newsletter.
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And all of those projects help busy professionals and retirees avoid mistakes and grow their wealth by
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simplifying their investing, taxes, and retirement planning. And yes, today will
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be a deep dive. You could even call it an expose on target date funds. So, first though, let me do a quick review
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of the week. This one is from 0302 Explorer who left a five-star review on Apple Podcasts and said, "Honest broker,
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Jesse puts out some great retirement and personal finance content that covers some issues that other producers lack. I
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particularly appreciated how he tackled projecting inflation and HSA, that's
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health savings account issues. He's relatable, factual, and responds to emails. Thank you for the kind words,
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Explorer. And yes, I do love responding to your emails. If you've ever gotten a
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uh you know a 300word email response from me. I apologize for the length. I think sometimes writing a long easier is
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probably easier than writing a short one. It's like Pascal said, I would have
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written a shorter letter, but I didn't have the time. But anyway, explorer, thank you for the kind words. Drop me an
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email to jessebinest.blog and I'll send you a super soft t-shirt. And I know I'm a little behind on
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t-shirts. I have to get a couple months worth of t-shirts shipped out. So, if you're waiting on a t-shirt from me,
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don't worry. It's on the to-do list. It'll happen soon. But let's get to the
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main show today. Let's focus on target date funds. I want to give a a special
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shout out to a couple other retirement nerds who set me down this path for this episode. So, Frank Vasquez, uh,
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especially his episode 333, 333 of his podcast, Risk Parody Radio. Then, Ben Felix and Cameron Pasmore, specifically
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their episode 374 of uh, Rational Reminder podcast. They produce the Rational Reminder podcast. And then,
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Professor David C. Brown who conducted a lot of the research that I'll be citing
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today. We'll link to all the relevant research and podcast episodes here in today's show notes. The simple fact and
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I'm I'm kind of excited about this topic today. I'm excited to be talking about
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it because up until I don't know a month ago, a couple months ago, I had this one
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particular set of thoughts about target date funds. Very positive thoughts. And those thoughts were based on all the
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learning that I'd done over the past 12 years. you know, everything that I've
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ever consumed and and whatever of those topics were based about target date funds left a very positive set of
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thoughts in my head about target date funds. And if you look at other experts out there, Rammit Seti or Christine Benz
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or John Bogle himself are all on the record saying some pretty good things about target date funds. And when they
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said those things in the past, you know, especially if they were referring to what I'll call the right type of target
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date funds, I think those experts had a totally valid point. Somewhere in the filing cabinet of my mind, that helped
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me shape my positive opinion about target date funds. But with new information and new research, I had to
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shake off my prior opinions about target date funds and and revisit them. And so
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that's what created today's episode. So, in today's episode, I'll explain to you
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what target date funds are and how they work, just how dominant they are in the American retirement landscape, which is
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one of the reasons why I think it's so important to talk about them. We'll talk
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about the glide path concept, which is fundamental to target date funds, and I'll explain these five key factors of
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target date fund performance, and why those five key factors often lead to underperformance, which is one of the
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main reasons why we're here today. I'll talk about this thing called the curse
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of average and what you might want to think about instead of a target date fund and kind of what the spectrum of
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investing looks like. On that topic, I will talk a little bit about bread. Yes, the food. But I promise you, bread has
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something in common with target date funds. And last, I'll share with you a couple examples of target date funds
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that I think are the best of the bunch. And I'll share with you the exact criteria that I use to evaluate them.
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So, let's get going. A target date fund is a type of investment fund designed
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ideally to simplify your retirement investing. Instead of building and managing a portfolio yourself of many
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different funds, you choose a single fund labeled with a year that's close to
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your expected retirement date, such as a 2045 fund or a 2060 fund. And the fund itself then automatically manages your
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investment mix over time. And the core feature of a target date fund is its glide path. You know, think of a plane
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coming into land, a glide path. And that glide path determines how the portfolio's risk level changes as the
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investor ages. Early in an investor's career, the target date fund typically
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holds mostly stocks because younger investors have many years before retirement and they can tolerate more
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market volatility. But as the target date itself approaches, the fund gradually shifts toward bonds in an
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effort to reduce the impact of large market downturns near retirement. Most target date funds are structured as a
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fund of funds. And what I'm about to say here is an incredibly important set of
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details. Okay, very very important. So instead of the fund holding individual securities directly, target date funds
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usually invest in a collection of underlying mutual funds or index funds. So that the target date fund manager
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decides how much to allocate to each asset class such as US stocks or international stocks or bonds and then
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periodically rebalances the target date fund portfolio to maintain the intended allocation. So it's a very important set
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of detail that it's a fund of funds and we'll dive into those details much
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further today. Now if we combine the glide path idea with the fund of funds idea, I want to give you a quick example
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of how a particular target date fund works. So I'm going to share the the Vanguard family of target date funds as
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they've published a very informative web page explaining their glide path in
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great detail. We'll link that glide path link here in the show notes. So Vanguard
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for all their target date funds, they define five age-based markers in a person's life or career. So at age 20,
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they assume that someone is is starting the early career phase of their life. And then at 40, the second phase starts.
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They call it midcareer. At age 60, they define that as the beginning of the transition to retirement. Age 65 is when
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retirement actually occurs. And then at age 72 is what they call the beginning of retirement withdrawals. And that's
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based on research that they've done. They said the average retiree begins withdrawing from their portfolio at age
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72. Going back starting at age 20, Vanguard has its investors in a 90% stock 10% bond asset mix. The stocks
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themselves are a 60/40 mix of US to international and the bond portion is 70% US to 30% international. And that
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9010 overall allocation remains until age 40. And that's when for Vanguard, the glide path begins. So over the
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following 20 years between ages 40 and age 60, the allocation shifts from 90% stocks down to 60% stocks and from 10%
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bonds up to 40% bonds. That glide path continues onto age 65, by which time the overall allocation is 50/50. But in the
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five years between 60 and 65, the Vanguard funds, they add in uh short-term TIPS. TIPS being, you know,
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treasury inflation protected securities. It's a type of bond that's protected
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against inflation or has a hedge against inflation. And about 10% of the portfolio ends up in TIPS by age 65. So
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40% being other types of bonds, 10% TIPS, and 50% in stocks by age 65. And then the glide path continues another 7
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years to age 72 which as I said before that's when Vanguard's research states
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is the average age when portfolio withdrawals actually begin. And at that point the Vanguard target date fund it
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reaches its final allocation 30% stocks and 70% bonds. 16 of that 70% is in the tips bonds and that allocation is
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maintained going forward for ostensibly the rest of the investor's life. So that
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right there is how a glide path works. Now, let me pivot really quickly, talk a little bit about history. Back in the
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early 2000s, we have to understand that the default investment in many American retirement plans was cash or very, very
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short-term treasuries. After all, cash and treasuries are both very quote unquote safe, low-risk investments. So
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rather than automatically investing someone's money into something slightly more aggressive or something that had
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more long-term growth, the 401k plans back in the early 2000s and before would play it safe with an ultra low-risk
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asset. So you would have people who who were saving in their 401ks for years, if
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not decades, and maybe they assumed their money was being invested in some way, but unless they went in and
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actually maybe opted into a true investment, that money might just be sitting there in cash again for years or
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decades. And that's not a very good outcome. In fact, it's an outright bad
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outcome. But Congress changed things. In 2006, they passed a law called the Pension Protection Act. Took me about
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five takes to get through that word, which basically mandated that every single retirement plan out there had
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these things called qualified default investment alternatives. QDIA, qualified default investment alternative. And as
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the name might imply, the point was that you can't just put all the people in the
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401k plan in cash as a default. You have to have some sort of actual investment alternative that can act as a default.
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And target date funds were one of the very limited options that qualified as one of these QDIA qualified default
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investment alternatives. And you know, their appeal was their ease. Investors could hold one diversified fund possibly
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for decades and decades of time while the asset allocation automatically adjusted as retirement approached. And
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this idea, at least on its face, makes sense. It aims to provide a hands-off, a diversified, a long-term investment
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strategy. All good things and all related to an investor's expected retirement timeline. Now, Morning Star,
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wellrespected institution, estimates that almost $5 trillion today sits inside of target date funds. If you had
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a h 100red million people, right? Think about that. If you had a 100 million people who each had $50,000 inside of a
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target date fund, that would get you to $5 trillion. I only put it in those terms because 100 million people is
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about twothirds of the American workforce or about 40% of the entire population of American adults and
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$50,000 while not enough to retire on is a pretty good chunk of change. And I would wager that any of you listening,
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for example, that you would care and you would certainly keep track of a $50,000
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line item on your balance sheet. So the magnitude of what we're talking about
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here today is as if half the adults you know have $50,000 on the line. It's kind
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of a big deal. And then approximately twothirds of all new dollars going into workplace retirement plans are going
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into target date funds. So again, it's as if more than half of all the working
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people, you know, are putting their retirement dollars into these types of funds. It's a big deal. And I can say
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for myself that currently my 401k is through Empower, which is a really big kind of 401k institution. Now, I'm not
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using a target date fund in my current 401k. I built a simple three index fund portfolio in that account. But at my
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previous 401k, I was using a target date fund. It happened to be a black rockck fund. And we'll come back to Black
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Rockck later today. And I know for a fact that the reason I got interested in personal finance and investing in the
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very first place is because my first ever postcol job, I was using a 2050 target date funds through Fidelity and I
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was watching it grow. So target date funds are everywhere. But not all target date funds are equal. In fact, many of
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them are not only less than optimal, many of them are outright bad. And that's one of the big reasons why I'm
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here talking to you today. So, why do I say this? Now, what's this the simple
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summary takeaway for today's episode? It's that the average target date fund
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in today's American retirement plan underperforms by an average of 1% per year. Underperforms by an average of 1%
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per year. Don't worry, I'll explain this, but the takeaway is that 1% per
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year underperformance. If someone starts using a target date fund at 22 and holds
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it until 82, after all, it is supposed to be a one-stop shop for life, that could be 60 years of underperformance.
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If you punch that into a calculator, if you punch in 1% underperformance for 60 years, it would eliminate 44% of that
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investor's would be wealth. Instead of having $1 million, that investor only
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has $560,000. Now, that is obviously a tremendous claim. It needs to be explained. It
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needs to be backed up. But the the first and most obvious place to start, I think, is uh 1% underperformance. Well,
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compared to what, you know, what benchmark are we using to say that target date funds underperform
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something? And this result comes directly from professor David C. Brown's research. What professor Brown did was
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he he looked across the target date fund landscape at any one particular vintage.
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So, a vintage almost like wine. Think of the year. So, 2040 target date funds. 2040 being a particular vintage. He's
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looking across every single 2040 target date fund. He looks at Vanguard's 2040.
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He looks at Fidelity's 2040 funds because Fidelity actually has two different 2040 funds. One is totally
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passive with index funds, but one is active. One uses active funds at Fidelity. And he looks at Black Rockck's
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2040 and State Streets 2040 and Troll prices 2040, etc., etc., etc., every single 2040 fund out there. And he takes
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the average allocation of all of them. How much in US stock? How much in international stocks? how much in US
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bonds, international bonds and other stuff. That average allocation to stocks and bonds and other stuffs that that's
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the study's benchmark. But more specifically, the study benchmark portfolio uses only index funds. So
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again, the 2040 benchmark against which all of the individual 2040 target date funds would be compared was simply the
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average allocation of all those funds in terms of stocks and bonds and anything else but recreated as a totally passive
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indexonly fund. Then Professor Brown went through and compared each individual 2040 fund against that
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benchmark. And on average, the individual 2040 funds underperformed this benchmark by 1% per year. Now,
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where does that underperformance come from? Well, the first place is fees. On average, 0.55% or 55 basis points,
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right? Just over half a percent. 55 basis points of the underperformance is due to fees alone because remember the
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benchmark portfolio it's only index funds so it's very very low cost professor Brown used Vanguard index
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funds specifically so his benchmark portfolio had fees lower than 0.05% 120th of a percent five basis points and
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what this is telling you in short is that many target date funds have fees that are half a percent 6.7% or even
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higher some fund providers charge upward of 1.2 2% upward of 1.5% per year. That's just for the investments and
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that's just not a good price in today's investment landscape. And I'm not saying
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that target date funds should be free. I'm not saying that it should have the
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same cost as an index fund. But these products can be done so simply that the fees ought to be very very low.
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Vanguard's 2040 fund, for example, has an all-in cost of 0.08%. Eight basis points, 8 hundredths of a
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percent. Fidelity's index 20 240 fund is.12% or 12 basis points. Now that to
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me is the cost I would expect to pay for a target date fund. So fees are that the
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biggest component of the underperformance. But where else does the underperformance come from? The next
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biggest culprit is actively managed funds inside of the target date funds. So even before we look at fees, the
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active funds that are inside of some target date funds underperform their comparable indexes by about 0.45% or 45
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basis points per year. So let's go back to the Vanguard 2040 fund to explain
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this one. Vanguard's 2040 fund has four sub funds inside of it. A US stock index
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fund, an international stock index fund, a US bond index fund, and an international bond index fund. All four
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of those are index funds. very very cheap. But not all target date funds are composed of only index funds. In fact,
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many are not composed of any index funds. I'm going to pick on Fidelity a little bit here because I know they're
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big enough to handle it. They do offer an index target date fund like I mentioned before, but they also offer
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active target date funds. They're 2040 active target date fund. The ticker is
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FF FFX. That's four Fs and then an X if you're curious. It holds 15 US stock
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funds. all of which are Fidelity funds and all of which are active. It also holds 10 international stock funds, all
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Fidelity, all active. 15 different bond funds and a smattering of individual bonds, too. It's a lot. It's also all
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relatively high cost because it's actively managed and there are more people at Fidelity working behind the
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scenes to manage that account, manage that fund, I should say. And that's expensive. Fidelity is far from alone
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here. And in Fidelity's defense, that particular 2040 active target date fund
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has performed right in line with Fidelity's own index target date fund over the past decade. But the fact is
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that many other fund providers also offer target date funds that hold their own active funds, only playing with
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their own active funds. And just what do we know about active funds in general? Well, we know that on average they
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underperform their passive counterparts. You know, it reminds me of the culinary
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stories about how a cook can use a bunch of old, possibly bad food and blend it together into a soup. That's not the
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soup that you want. But what we have here are fund managers, many of whom you've heard of, who blend together
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their active funds into target date soup. And they know that target date soup is a approved investment type. It's
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an approved food item inside of the 401k and 403b plans. and they know that twothirds of all new dollars going into
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retirement funds order some form of target date soup. To me, this is a very bad problem. Those are the two biggest
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culprits of underperformance here today. Target date funds provide worse performance simply due to their often
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active management and they do so at much higher fees than passive funds. Worst performance plus higher fees equals 1%
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per year underperformance. Here's a quick ad and then we'll get back to the
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show. Did you know my written blog, The Best Interest, was nominated for 2022 Personal Finance Blog of the Year, and
00:18:45
it's been highlighted in the Wall Street Journal, Yahoo Finance, and on CNBC. I
00:18:49
love writing, especially when that writing is to share financial education. And I usually write one or two articles
00:18:55
per week. You can read them all at bestinterest.blog. Again, the web address is bestinterest.blog.
00:19:04
Check it out. Now, I said there were going to be five negative components of target date funds, and we've only
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covered two. The third one, the next one, is what they call tactical allocation changes. So, let's use
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Vanguard as our example. Back in the mid2010s, Vanguard's target date fund managers
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decided on the whole that all of their target date funds didn't have enough stock exposure, and so every single one
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of their target date funds shifted higher in their stock allocation. That was a a strategic long-term shift over
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their entire target date portfolio. Now any fund manager is welcome to do the same kind of thing or they can say
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something like you know what normally we'd be 6040 US to international on our
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stocks but we're going to shift to 7030 or we feel like interest rates are going
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to drop so we're going to overweight our fund into bonds. These are active tactical decisions that the fund
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managers make at some sort of high allocation level and they are essentially either changing the
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predetermined glide path or they are chasing returns or predicting returns in some way. And these decisions on average
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reduced the returns of target date funds by about 10 basis points or onetenth of
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a percent per year. That's the third big issue with target date funds is that
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sometimes you have managers who are trying to be smart. I'm sure they're not
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trying to they're not trying to hurt investors obviously, but on the whole when those fund managers do something
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like that, they do end up hurting investors. The fourth issue, I guess the more I think about it, you can make an
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argument that the fourth issue I'm about to say is just a symptom of the first
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three issues. But the fourth issue is the amazingly wide dispersion between different target date funds. In
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professor Brown's study, he found that the annual rate of return difference between the best target date funds and
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the worst target date funds of the same vintage, meaning you know the same say 2040 target year, that the best versus
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the worst funds had an annualized return difference that was 3% per year. And the
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most egregious quarterly dispersion, so in a single quarter, was a full 23%. Meaning during one particular quarter,
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fund A might have returned positive 5%. And fund B returned 18%. Now admittedly,
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Professor Brown would admit this. This is a cherrypicked statistic, but just imagine two investors who believe they
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are invested in basically the same thing. After all, they both own a 2040 target date fund. One investor though
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sees his portfolio go up by 5% in a given quarter and another investor sees hers go down by 18% in that same quarter
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or another way of looking at it is that over the next 20 or 30 years their annualized returns end up differing by
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3% per year. That's a massive difference. Now what happens when one investor gets say 5% a year for 30 years
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and another investor gets 7% a year for 30 years with typical 401k annual contributions. the difference in their
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two returns is easily going to surpass half a million dollars. I mean, that's
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what we're talking about here is the differences of half a million dollars between two investors who think they are
00:22:01
invested in basically the same thing. And the point is that for a fund type that at least to me is marketed like a
00:22:07
commodity, it's anything but a commodity. And now what do I mean by that? I mean that all gasoline, as far
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as most of us know, is basically the same. It's a commodity. sugar and table
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salt and white rice are basically always the same across brands. Milk and eggs and baby carrots are basically the same
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across different brands. And that at least to me is how target date funds are at least marketed to us. But what this
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study shows and what we're here to talk about today is that that's not how it
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works in reality. A much better analogy, equally as ubiquitous as gasoline or baby carrots, would be the common
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hamburger. Yes, every hamburger involves a beef patty between a bun, but every restaurant from the fast food
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juggernauts down to the local diners to the Michelin star, you know, gourmet restaurants, they all do hamburgers
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their own different way. And to suggest that all hamburgers are the same, while yes, they share some common traits, they
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are far from identical. And so that's why my fourth major drawback here is the
00:23:03
dispersion in results. for something that is marketed at least to the the lay person as being largely uniform. The
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results make us realize it's anything but. And fifth is what I would describe
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as the illusion of choice. So yes, Vanguard and Black Rockck and Fidelity, at least on the index side, and some
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other providers do have some really good best-in-class target date funds. But does your 401k or 403b have those ones?
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Maybe not. Most retirement plans only have one single family or one single fund provider of target date funds. And
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as I mentioned earlier, my very first 401k plan only had Fidelity target date funds. I don't exactly remember if it
00:23:42
was the active or the index kind. I don't own it anymore. My previous employer had only the Black Rockck
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target date funds. And I look at people's account statements all the time. I've seen many of the target date
00:23:52
fund providers that make up the bad results that we've covered here today. So, even though, as we'll discuss in a
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few minutes, there are some target date funds that I believe are on the good side of this conversation, there's a
00:24:03
stronger likelihood that any individual person out there is going to have one of
00:24:06
the limited target date fund options in their retirement plan that's on the bad
00:24:10
side. You know, those target date funds aren't very good. Let me now slightly
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pivot to something called the curse of average. Some people see this curse as a total failure of target date funds. I
00:24:19
see it as a a smaller issue than that, but an issue nonetheless. So the curse of average is an idea that designing any
00:24:25
product right whether it's an investing product or something a consumer product
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an educational product anything that designing it for the average user is just a flawed design strategy because an
00:24:36
average person who perfectly represents the average in all dimension well they rarely if ever exist. So when you design
00:24:43
for the average you create a product that ends up being mediocre for everybody rather than truly helpful for
00:24:49
any one person. In other words, how could Vanguard or any other fund manager design one fund that is supposed to be
00:24:56
quote unquote right for everybody between ages 43 and 48? How could they possibly take into account that person's
00:25:03
savings rate if they reach retirement different from age 65 or if they begin withdrawing different from age 72? How
00:25:10
can they take into account the outside investment accounts or how those accounts are invested? How can they take
00:25:15
into account this person's guaranteed income in retirement like social security or pensions? Their withdrawal
00:25:20
needs in retirement, their human capital and their future earnings potential, their need, ability and willingness to
00:25:26
take on risk. I mean, the list just goes on and on. And I think one possible viewpoint here is well then the product
00:25:32
that tries to answer these questions and and tries to be this average product, it
00:25:36
should never ever exist in the first place. It's got a million holes in it and the curse of average is so glaring
00:25:42
that nobody should ever put money into a target date fund. I understand where that argument comes from. I'm not quite
00:25:47
so severe on it. Instead, my take on it is something I'm going to steal from the
00:25:51
words of John Bogle himself. He said, "Target date funds are not a panacea,
00:25:56
which if you're like me and found the SAT reading section a little hard, a panacea is a solution or remedy for all
00:26:02
difficulties or diseases." And Bogle is saying that a target date fund is not a
00:26:06
panacea. In other words, it's got flaws. It's not perfect, but in the right
00:26:10
situations, it is different than saying it's, you know, outright terrible. It's
00:26:15
never going to be perfect, but it also doesn't have to be terrible. Imagine this as an example. Uh, we've got a
00:26:20
45-year-old person who's just discovered this world of personal finance and investing for the very first time. This
00:26:25
person is literally at square one. They're eager and ready to learn. They've got some money saved in various
00:26:30
accounts, and well, it is invested really poorly, even if they don't know it yet. There's no cohesive investment
00:26:37
strategy or financial plan that kind of defines what they're doing with their
00:26:40
money. They just have, you know, 50 different ticker symbols of just random funds. And if that person decides on day
00:26:46
one of this their new financial planning beginnings and if they decide to invest
00:26:51
in a reasonable target date fund based on their future retirement date, I think that's a step in the right direction.
00:26:57
It's way better than what they've been doing before. Is it their set and forget
00:27:00
solution for the next 30 years? No way. But is it good enough for the next year or two while they read some books and
00:27:06
some blogs and catch up on some I don't know maybe they catch up on some podcasts? Yes. I believe that a a good
00:27:11
target date fund is the perfect kind of holding pattern while that person tries to figure things out. That's the curse
00:27:17
of average and and that's the reason why target date funds are likely never going
00:27:21
to be perfectly designed for you in particular. But I don't think we need to
00:27:24
throw out the baby with the bath water. That's just my two cents. Pivoting now
00:27:28
to an important question. What should you do instead of investing in a cruddy target date fund? Assuming that's what
00:27:34
you've been doing in your retirement account. So, going back to the Vanguard
00:27:37
funds we discussed before, there were five unique investment classes inside of Vanguard's funds, right? US stocks,
00:27:43
international stocks, US bonds, international bonds, and then those tips, inflation protected bonds. And you
00:27:49
might be tempted to recreate or build your own target date fund using individual index funds in your 401k.
00:27:56
five individual index funds representing those five asset classes. Well, I think
00:28:00
that's a little bit overkill actually, and I'm also just willing to bet that
00:28:03
most of you will not have access to all five of those asset classes in your 401k
00:28:08
or 403b. But most retirement plans today do offer some index funds. There have been enough lawsuits over retirement
00:28:16
plan fees such that low fee index funds are now usually part of the investment menu. So, at a bare minimum, if you're
00:28:23
going to try to recreate your own target date fund, it's really helpful if you
00:28:26
have access to just the following two funds. A total US stock market index fund and a total US bond market index
00:28:34
fund. Now, coming in as a really nice third place would be a total international stock market index fund.
00:28:40
Or combining number one and number three would be a total world stock market index fund including every country
00:28:46
including the USA. Now, if you don't have a total US index nor a total world
00:28:51
index, but you do have an S&P 500 or other large cap US index fund, that's a
00:28:57
a fine substitute. The S&P 500 captures something like 3/4 of the US market and
00:29:02
about half of the global market. So, if that's all you have access to, well,
00:29:05
that'll do. There are good arguments both for and against investing in international bonds. And then this is
00:29:12
speaking as a as an American retiree, as an American investor. Now, I don't see a
00:29:16
particularly large need to do so. Uh, and there are many good arguments for and against investing in inflation
00:29:22
protected bonds tips. I don't think you really need them in my opinion. But if
00:29:26
you have access to the world of stocks via a passive index fund and at least to US bonds via a passive index fund, and
00:29:32
that access comes at really, really low fees, which it ought to because these are index funds, then you're golden. you
00:29:37
can now create this specific asset allocation specific to you to your financial plan. And that allocation will
00:29:43
hopefully mirror some of what you're doing or at least take into account some
00:29:47
of what you're already doing in your other accounts that you own. Now, why am
00:29:51
I keeping it so simple? Well, I'm doing this a little out of order, but I'm
00:29:54
going to quickly read from a recent article I wrote because if you understand bread, yes, the food bread,
00:29:59
you can better understand investing and specifically this target date fund or simple investing strategy that we're
00:30:05
talking about today. Because at its most basic level, bread contains four core ingredients. And each one serves this
00:30:11
specific role in the chemistry and the structure of the loaf of bread. Flour provides structure. There are these
00:30:17
proteins in flour that combine with water to form gluten. And gluten is the stretchy network that traps gas bubbles
00:30:23
and allows bread to rise. Water is the second ingredient. Water hydrates the flour, activates gluten formation. Yeast
00:30:29
is next. Yeast leavvens the bread, makes it rise. And then salt. Salt is the fourth ingredient, controlling the
00:30:35
fermentation of the yeast, improving the flavor of the bread. Without salt, bread
00:30:39
is usually flat. The dough can become sticky and weak. And those are the core four: flour, water, yeast, and salt. And
00:30:45
granted, many people do add more ingredients. Maybe some sugar or honey for flavor to feed the yeast. Some fat
00:30:50
like butter, oil, or dairy for tenderness and richness. Eggs can also add richness and some structure. Whole
00:30:56
grains or seeds can add some flavor and nutrition. The point is that bread is not complex. Each ingredient though has
00:31:02
an important role to play. And what's the point? Why am I talking to you about
00:31:05
bread? Well, one, it's simple. There aren't dozens of ingredients. Two, every
00:31:09
ingredient has a specific job, a specific domain, a reason why it's there in the in the recipe. And largely, those
00:31:15
jobs don't overlap with one another. And then three, in varying proportions though, those very few unique
00:31:22
ingredients can create many, many different outcomes in bread. Right? You can reduce the flour and add water, add
00:31:29
seeds, reduce this. You can just play around with the core four ingredients or you can play around with the core four
00:31:34
plus a couple more ingredients in different proportions and create many different types of bread. I was thinking
00:31:39
about this because I was looking at a prospective client's portfolio and it was constructed using a 10 to 20%
00:31:44
allocation of each of the following eight Vanguard funds. So VTI total which is a total US stock market. VO which is
00:31:51
a S&P 500 fund. VV which is a large cap fund. VUG which is a growth stock fund.
00:31:58
MGK which is a mega cap growth fund. VGT information sector fund. QQQM which is a
00:32:05
NASDAQ 100 fund. And then VO which is a midcap ETF. And some of you might think well those are all different
00:32:11
descriptions right? Growth versus information versus meggaap S&P 500 versus NASDAQ. They're different. It
00:32:17
seems like each fund is probably providing some different diversification to this person, but that's not the case.
00:32:22
This is a portfolio of various rappers, but all of those rappers are basically holding the same stocks. If instead I
00:32:28
put this portfolio in bread terms, it's as if their recipe called for two cups
00:32:32
of bread flour, one cup of all-purpose flour, 1 cup of high gluten flour, half a cup of pizza flour, 1/4 cup of premium
00:32:39
organic white flour, no water, no yeast, no salt, no sweetener, just flour. And that's not good bread. And what I just
00:32:46
read to you wasn't a good portfolio. I would much rather advocate for a portfolio where every quote unquote
00:32:51
ingredient has a clear job and just one job. We don't need a hundred ingredients. We don't need too many
00:32:57
ingredients doing the same thing. Any portfolio, but especially a retirement portfolio, I think needs four vital
00:33:03
distinct ingredients. The first one is appropriate risk level. Your stocks versus bonds versus other assets mix
00:33:10
matters far more than which specific funds you pick. This asset allocation decision should be related to how much
00:33:16
money you need from the portfolio and when you need it. It needs to be part of the financial plan. It needs to be
00:33:21
related to the financial plan. So that's the first ingredient is appropriate risk
00:33:24
level. The second ingredient is broad diversification. You want to avoid concentrated bets. You want to avoid
00:33:30
stockpicking. You want to avoid redundant funds that own the same companies. A retirement portfolio should
00:33:35
resemble the entire market. And you can. You don't have to. And maybe it's not
00:33:40
always a smart thing to do, but you can accomplish this with one single fund. Often though, a few funds leads to
00:33:45
better results. Perhaps akin to baking bread from just one pre-made box recipe versus combining the ingredients
00:33:51
yourself. So that's the second one is broad diversification. The third ingredient, low costs. I don't think
00:33:56
there's really much of an explanation needed there. And then the fourth ingredient is behavior you can stick
00:34:01
with. Your portfolio should be simple enough that you can understand it, tolerate it during crashes, stick with
00:34:06
it for decades. Now, if you need some flavor in your portfolio to make it more tolerable behaviorally, so be it. Some
00:34:13
people, they need cinnamon and raisins in their bread. And some investors feel like they need an allocation to gold.
00:34:18
They need to own some Costco stock. They need to have exposure specifically to the aerospace sector. Okay, I can live
00:34:25
with it as long as that makes you not jump off the ride as long as it's, you
00:34:28
know, in relatively small proportions. Again, think about bread. It's one thing
00:34:32
to say half a cup of raisins in an entire loaf. It's a different thing to say three cups of raisins per loaf. You
00:34:39
know, as long as it's done uh tastefully in small amounts, I I understand why
00:34:43
people sometimes need to add some flavors to their portfolio to ensure that it's a portfolio that they can
00:34:48
stick with for the long run. So again, the takeaway from this bread idea is to know your ingredients and know why
00:34:53
you're using them. And most investors, I think, will make it more complex than it
00:34:58
really needs to be. Here's a quick ad and then we'll get back to the show.
00:35:03
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totally true and a good reason to ask for ratings and reviews. But I have something more important, at least more
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too, that's great. If you like what I'm doing, please share it with me. It's
00:35:42
such a great feeling to read your feedback. I'd love to read your review or see a rating on Apple Podcast or
00:35:48
Spotify. Thank you. Back to our regularly scheduled program about target date funds. Of those four key
00:35:54
ingredients, which again were appropriate risk level, broad diversification, low cost, and behavior
00:35:59
you can stick with. I think we figured out today that many target date funds are too broad and too average to
00:36:04
pinpoint the appropriate risk level for you specifically. So good on average maybe, but not good specifically when it
00:36:11
comes to risk level. And in some cases, the costs of the target date fund are far from being low. As far as risk level
00:36:17
and low costs, different target date funds simply don't meet muster there. But I think that many target date funds
00:36:24
do provide broad diversification and actually they are fantastic behaviorally. One of the double-edged
00:36:29
swords of convincing people that target date funds are a one-stop shop is that target date funds have some of the
00:36:34
lowest amount of investor turnover of any funds in existence. In other words, people really do buy and hold and hold
00:36:41
and hold their target date funds. Now, I think you can and should aim to create your own portfolio such that it does hit
00:36:49
a risk level appropriate for your financial plan and that the costs are really low. If that happens to be
00:36:54
through a target date fund, okay, and and we'll talk about that in a few minutes, but oftentimes it isn't. So,
00:36:59
before I dive into a couple target date funds that I think meet muster, let me first explain to you my criteria for
00:37:05
evaluating these target date funds. Again, first was fees. Lower is certainly better. Uh, and as those fees
00:37:11
start to slide up from say a tenth of a percent to 0.15% to 2% or higher, I'm
00:37:17
just asking the question why, you know, why am I paying for a target date fund that has a fee of half a percent per
00:37:23
year when Vanguard or Fidelity or BlackRock are selling me an index passive based target date fund that's a
00:37:29
tenth of a percent. That's, you know, that's the cost of half a percent. So
00:37:33
fees are very important. Uh, my second criteria was passive management. This goes handin-hand with fees. But as we
00:37:38
spoke about earlier, two major causes of this target date fund underperformance are both the fees themselves, which will
00:37:44
always have a drag on performance, but also the choice to go active, which even before fees are counted, the active
00:37:50
management led to an average of uh 45 basis points of underperformance. So passive matters a lot, at least to me.
00:37:58
Third, I consider any sort of an exotic investment inside of a target date fund to be more negative than positive. If a
00:38:04
target date fund, for example, has real estate exposure or commodities exposure or anything like that, I do think we're
00:38:10
over complicating it. And now, what I didn't do at all was grade the glide path itself. And the reason why is
00:38:16
because if we're trying to grade the curse of average glide path over a 60-year investing timeline, I'm really
00:38:22
not even sure how to begin. I think everyone would probably fail if we're doing that. Even though we I didn't
00:38:27
grade these funds on the glide path, I will comment on it in a few minutes. Now, a few different uh research papers
00:38:33
site between 50 and 60 unique fund families out there in the American retirement landscape. Again, Vanguard is
00:38:40
one family. Fidelity has two different families, passive and active. Black Rockck has one family. So, there are 60
00:38:46
different families of target date funds out there. I did not look at all 60, but
00:38:50
I did look at the top five because the top five families of target date funds own over 80% of the target date fund
00:38:58
market. They are in order. Vanguard at 37%, Fidelity at 14%, Troll Price at 11%, Black Rockck at 10%, and American
00:39:08
Funds Capital Group at 8%. In short, Vanguard is best. Great on fees, fully passive on the exotic investments axis.
00:39:17
I know some investors might stick up their nose at International Bonds and TIPS, which are both in Vanguard's
00:39:22
target date funds. Fair enough. But I've seen far worse since like there is a
00:39:25
spectrum to investing here and having international bonds and tips isn't that
00:39:30
bad on that spectrum. But anyway, Vanguard is best. Next for me is Black Rockck and their life path series of
00:39:36
target date funds. Again, great on fees, fully passive. They too have a small exposure to tips. They also have an
00:39:42
exposure to real estate investment trusts or REITs. One interesting note is that Black Rockck's life path series
00:39:48
starts at almost 100% stocks for investors in their early 20s and then decays down to only 20% stocks by the
00:39:55
time an investor is 85 years old. So that's just an interesting glide path there. Uh next in line for me is
00:40:01
Fidelity. A little jackal, a little hide because their Freedom Index series, the
00:40:06
passive series, Freedom Index, it's a great family of funds, but their actively managed freedom series is well
00:40:13
actively managed. I also think it's a little uh challenging that one one is called freedom index and the other one
00:40:19
is just called freedom can be a little confusing. The passive family has fees of 12 basis points. Excellent. While the
00:40:25
active series costs between 50 and 75 basis points. The passive series is everything that we want investing wise.
00:40:32
The active series has some serious flavor to it and I believe it's just not needed. And that brings us to a tie for
00:40:39
last between Troll Price and American Funds Capital Group. Can you guess why? Well, it's because they're all high fee
00:40:46
and all actively managed funds. The fees are in that 50 to 60 basis point range.
00:40:51
And the portfolios have lots of expensive exposures to these small corners of the market with the target
00:40:56
date fund portfolio managers having discretion over when to jump in and out of funds, when to overweight or
00:41:02
underweight different parts of the portfolio, etc., etc. All that behavior that decade after decade becomes more
00:41:08
and more clear to us that it sounds good in theory. You know, it sounds good to have someone smart who is making lots of
00:41:14
changes that they think will be helpful to us, but that research shows decade after decade on average is detrimental
00:41:21
to the end investor in practice. The more active management, the worse the fund is likely to perform. Troll price
00:41:28
and American Fund Capital Group are two easy and apparently quite popular examples of target date funds where I
00:41:34
would highly recommend looking for a better alternative. And again, when it comes to, you know, Vanguard, Black
00:41:40
Rockck, and Fidelity's passive funds, I still don't think you should lean on
00:41:44
these funds as your forever solution to investing. I don't think that makes sense for anybody. And the reason again
00:41:49
is the the curse of average, it's the glide path problem. The idea that these
00:41:54
target date fund providers have gotten your particular risk exposure correct for a 60-year period or even a 10-year
00:42:02
period, probably not. So instead, if you need a place to park your money while you figure everything out, if you just
00:42:08
if you don't have any other really good options inside your 401k except for a
00:42:12
Vanguard target date fund, then fine, by all means, that's where these passively
00:42:17
managed lowcost target date funds can make sense. They're never going to be perfect, but they certainly can be good
00:42:23
enough. So today, we discussed what target date funds are and how they work. I hope you realize how significant they
00:42:29
are in the American retirement landscape with many people in your life likely having big sums of money in these target
00:42:35
date funds. We talked about glide paths and how the one-sizefits-all might lead to more problems than solutions. Mainly
00:42:41
though, we focused on the average underperformance of target date funds, which tend to underperform by more than
00:42:45
1% per year when compared to a very similar portfolio of pure index funds. We talked a little about bread, about
00:42:52
how a few simple independent ingredients in the right proportions can lead to many different recipes, successful
00:42:57
recipes, and quote unquote correct recipes. And last, we talked about how if you're unsure whether your retirement
00:43:02
plan has a good or a bad target date fund, how you can make some judgments for yourself. I really hope this episode
00:43:08
was helpful, maybe even eye opening. It certainly was eye opening for me. So, thank you for listening. Let me know
00:43:13
what you thought of this episode. Thank you for subscribing, for writing in with
00:43:16
your questions and comments. Thank you for listening to Personal Finance for Long-Term Investors.
00:43:20
>> Thanks for tuning in to this episode of Personal Finance for Long-Term Investors. If you have a question for
00:43:26
Jesse to answer on a future episode, send him an email over at his blog, The Bestinterest. His email address is
00:43:33
[email protected]. Again, that's jessevestinterest.blog. Did you enjoy the show? Subscribe, rate,
00:43:41
and review the podcast wherever you listen. This helps others find the show and invest in knowledge themselves, and
00:43:48
we really appreciate it. We'll catch you on the next episode of Personal Finance
00:43:52
for Long-Term Investors. Personal Finance for Long-Term Investors is a personal podcast meant for education and
00:43:59
entertainment. It should not be taken as financial advice and it's not prescriptive of your financial
00:44:04
situation.