Target-Date Funds II
A few weeks ago in my Target-Date Funds (also called Lifecycle Funds) blog, I outlined some of the advantages and potential problems with them. I promised to look at a simple model that you may choose to use to implement your own custom Lifecycle/Target Date Fund using existing ETFs.
In “Lifecycle funds: Taking a balanced approach to savings” Avi Nachmany is quoted “Too often investors left on their own are too passive, too lazy, too ignorant or too greedy and so they make bad choices,” he adds. “With these funds investors know they are doing the right thing rather than just buying the stock of the month.”. He believes that Lifecycle funds have staying power.
If you are an American who has access to one of the low-cost versions of these funds and Mr. Nachmany’s description applies to you, then by all means they will do the job for you. If you are a Canadian, given the cost of the available lifecycle fund, or an American/Canadian who would like to overcome some of the problems mentioned, I will describe a model that you could experiment with to arrive at a customized solution that is right for you.
So let’s look at the characteristics of target date funds available to U.S. and Canadian based investors. In the U.S. there is a large selection of Target-Date funds from which you can choose. I looked at three: Vanguard, T Rowe Price and Fidelity. These have annual fees ranging from about 0.2% for Vanguard to 0.5-0.8% range for the other two. (There were some U.S. based funds as well with management fees in excess of 1%, but I won’t discuss them further) The only Canadian Target-Date that I found was the Fidelity ClearPath family which had a MER of 1.9-2.55%. (This MER is no more outrageous than that of other Canadian mutual funds)
You must consider the drag on your returns, associated with the management fees of the funds. For what it’s worth, over a 30 year retirement, the asset erosion resulting from annual fees of 0.2%, 0.6% and 2.0% is 6%, 16% and 43%, respectively. So, while U.S. based investors have a much more favorable environment in which to exercise their target-date fund options. Canadians may wish to consider an ETF based customized solution, until low cost Target-Date ETFs become available.
Now let’s look at the composition of the funds and how that changes with years to/since retirement or age. In the “old” days they used to say that the percent stock component of your stock/bond portfolio should be (100-age). If you look at the composition of these four funds and assume that the average person retires at between 60-65, then you would not be far fro the following formulas modeling the percentage of stock in the portfolio:
• If you are still working: (120-age) max=90% (A1) • If you are retired: (110-age) min=30% (A2)
This is partly due to the increased longevity and the corresponding fear that a portfolio with too large a fixed income component is not capable of keeping up with inflation.
The international (non-U.S.) portion of each fund is about 20-25% of the stock allocation (not the total portfolio). By the way the same non-U.S./Canadian stock proportion applies to the Canadian Target-Fund offerings.
The primary difference between the allocations of the Canadian funds is that the non-international portion of the stock allocation is not purely U.S. based asset, but a mix of U.S. and Canadian stock, the U.S. proportion about the same as the international one. The allocations of the U.S. and Canadian offerings are weighted so that home based assets are adequately represented, since typically the predominant spending also occers in the home country.
Another difference worth mentioning among the funds, is that Vanguard funds have typically zero cash allocation (except for 5% in the well into retirement case) while the others have 20-40% cash or short-term bonds when close to or in retirement. It is a good practice in general for people who are pre-retirement to have cash reserves of 3-6 months of expenses and post retirement to have about two years’ worth of cash or short-term bond reserves, should there be a period of significant drop in stock prices, making them painfull to liquify.
So here is a simple model that you could use to create your own Target-Date Fund. First calculated the stock allocation using formula (A1) or (A2), depending on whether you are still working or already retired. Then divide the resulting stock allocation as follows:
• For U.S. investors: 75: 25 split between U.S. : International (B1) • For Canadian investors: 50 : 25 : 25 split between Canadian : U.S. : International (B2)
So, if you are comfortable with the allocations specified by the above fund providers, then this model will get you close to the average of their allocation.
Once a year you can recalculate the target asset allocations and then rebalance the portfolio as required. In post-retirement mode, you could cover your required annual withdrawal by harvesting the interest and dividends with any excess being reinvested and any shortfall being made up by selling assets which are above their target allocations. As you approach your retirement date, you’ll need to manage the transition between the pre- and post-retirement allocations, which have different allocation models. (At 65 the working model shows a 10% lower allocation to fixed income assets than the retired model). Specifically this can be done by selling stock and raising cash
All these ETFs have expense ratios below 0.35 (except EEM at 0.75%). So the overall portfolio headwind will be of the order 0.3% per year (very favorable as compared to the 1.9-2.5% for the Canadian lifecycle fund). Also using the ETF based portfolio you can place the fixed income portion of the portfolio into the tax-sheltered part. Furthermore, if you are more/less risk averse you can use a younger/older age for the calculation. So we have addressed several shortcomings of the Target-Date Funds.
You can also further fine tune the portfolio with ETFs (and CEFs for foreign bonds) by adding a small amount of high-yield bonds, TIPS/Real-Return bonds, unhedged foreign bonds and/or commodities. Even a small dose of these usually help reduce volatility and/or increase returns.
And, finally a postscript to the Target-Date Funds blog of a couple of weeks ago, in “When investors can’t leave their lifecycle funds alone” Jonathan Clements gives examples when some investors may be doing sensible things, even if it does not seem that way at first glance. Examples he gives are when: (1) 80% of funds goes to a Target Date Fund and 20% to emerging markets, junk bonds, etc (like in a core and satellite model that we’ll discuss in a future blog) or (2) buying both a 2010 and a 2020 fund when retirement is somewhere in-between.