A Do-It-Yourself Approach to Target Date Retirement Investing

Advertised as a one-stop shopping, automatic-pilot retirement vehicle, life cycle or target date mutual funds have become increasingly popular. These funds are aimed at individuals seeking an all-in-one retirement fund to invest his or her retirement nest egg, with a target date whose termination date approximates the date of his or her projected retirement (e.g., 2040).

The target date fund has the twin objectives of achieving an attractive rate of return while managing the risks for a cohort of investors who will be retiring on or about the fund’s target termination date. As the fund holder’s projected retirement date approaches, the fund manager’s number one job is to maintain a stable value. Over the life of the fund, the objective is to earn an attractive return.

One’s retirement income depends heavily upon what their retirement nest egg is worth when one retires. An ever-fluctuating market causes an ordinary stock mutual fund’s value to move around, often in large increments. Such a fund’s value could be up or, more problematically, down substantially on an individual’s target retirement date. No one wants to see their nest egg’s value sink dramatically in the last few years of their working life. An ordinary stock fund is, however, all too likely to lose substantial value in a bear market. And bear markets, which by definition see the market fall by 20% or more, are almost always unexpected.

Target date funds try to avoid a large near-termination value decline by shifting away from stocks toward bonds as the participants get older. The initial allocation ratio is heavily weighted in favor of stocks, but as the target date approaches, the ratio moves more and more toward bonds. Since the long-term rate of return on stocks is generally above that of bonds, the high percentage of stocks in the early years should yield an attractive overall rate of return. Notwithstanding its ups and downs, the stock market will generally produce an attractive long-term return. So, for example, over most 10-year periods, stocks outperform bonds.

In any given two- or three-year period, however, the stock market may not do particularly well. In an economic downturn that may cause a major decline in the stock market, however, bond (investment grade) values often hold up relatively well. Accordingly, increasing the portfolio’s bond component as the participant’s retirement draws near should help stabilize the fund’s value at that crucial point in time.

A life cycle fund’s portfolio management approach simply allocates value between stocks and bonds in a manner seeking higher returns in the earlier years and stability in the later ones. Most such funds invest the equity portion in a broad-based diversified portfolio of stocks that will perform much like an index fund.

Similarly, the bond part is put in a diversified portfolio of bonds that will perform much like an index fund of investment-grade corporate bonds.

The Impact of Expenses

Like all actively managed mutual funds, target date funds cost something to operate. Indeed, the target date fund charges both for expenses (commissions on trades, accounting, legal, etc.) and its management work (management fee). [In addition, those who invest through a broker will be assessed either an up-front sales load or a substantial 12b-1 fee (which takes out the sales fee over time).] The impact of these charges will vary from fund to fund, and there are a few very low-cost fund families, such as Vanguard, that offer low-expense target date funds. But it could be up to 1% of the amount invested annually. Thus, the net return to those who invest in the fund will be below the gross return by the amount of these costs.

With a bit of effort, however, an individual investor can produce the same kind of gross return investment performance as the target date fund manager and thereby save some of these investment management costs. The required tasks are straightforward and not particularly difficult or time-consuming. Indeed, most people will find putting the retirement money aside more difficult.

The specific formulas used to determine a target date fund’s ratios of stocks to bonds involve no magic. One is about as good as another. They all start out with a portfolio of mostly stock and increase the bond component as time passes. Moreover, the selection of stocks and bonds going into their portfolios is also pretty basic and is easily duplicated with index funds. In other words, the management of target-date funds does not involve any particularly heavy lifting. Doing it yourself should not put off anyone who can balance their own checkbook. Let’s explore just what is involved.

The Do-It-Yourself Approach

Whether one uses a target date fund or takes a do-it-yourself approach, an investment account would need to be established at a brokerage firm or a mutual fund family. Ideally, the account should be set up to qualify as a retirement account for tax purposes: A self-directed regular IRA, Roth IRA or a Keogh (for the self-employed).

Another possibility would be to invest through a 401(k) with one’s employer (assuming the plan allows some flexibility in investment choices).

Each of the above types of retirement fund vehicles offers significant tax advantages. With the Roth IRA, aftertax funds go into the account, but withdrawals at retirement are tax-free. The other types of retirement vehicles allow the contributions (up to the allowed maximum) to be subtracted from one’s current taxable income. At retirement, however, withdrawals are treated as taxable income.

Most people will qualify for at least one of the above-mentioned tax-sheltered retirement vehicles. But even if none of these tax shelters are available [IRAs are only available to those who either have no employer pension plan or whose incomes are below the government set threshold, Keoghs are only available to those with self-employment income, 401(k)s with an employer match are only available to those whose employer offers them], one can still set up and manage a fully taxed retirement account.

The next step is to begin funding by depositing a sum of money into one’s retirement account each year. For example, under current law, one who qualifies and has sufficient earned income can place up to $4,000 per year into a Roth IRA. Each year’s contribution could then be invested in a combination of stocks and bonds.

Next, we need to determine the appropriate stock-to-bond ratio with an easy-to-remember and simple-to-apply formula. Such a rule (that approximates that used by the target date funds) is to invest one’s age in percentage terms in bonds and the rest in stocks. So, a 25-year-old would have one-fourth of his or her retirement funds in bonds and three-fourths in stocks. The portfolio would move toward 65% bonds and 35% stocks at a retirement age of 65.

A 25-year-old who just began his or her retirement account with a $4,000 contribution would invest $1,000 into a diversified investment-grade corporate bond fund and $3,000 into a stock index fund. Either a no-load mutual fund or an exchange-traded fund that maintains a broad-based index portfolio of common stocks (e.g., the S&P 500) would do just fine for the stock portion. A similar type of index-based corporate bond mutual fund or exchange-traded fund would work well for the bond part.

One should select efficiently managed low-management-fee funds for both the stock and bond components. The net returns of such funds are likely to be quite similar to the gross return on the target date fund portfolios, which should in turn approximate that of their benchmark indexes.

In succeeding years, the investor should use whatever cash income is produced by the portfolio, plus that year’s contribution, to maintain the desired ratio.

How It Works: An Example

Let’s see how this might work in actual practice. Assume, for example, that at the end of the first year, the bond fund’s value increases to $1,060 (6%) and the stock fund grows to $3,300 (10%) with the income automatically reinvested in each fund. When the year-two contribution of $4,000 is added, the account’s total would rise to $8,360.

The individual, who has aged by one year, would now be 26. Thus, 26% of the fund should be allocated to bonds. That amounts to $2,173.60 of the account’s $8,360. Since the bond fund already has $1,060 in it, $1,113.60 of the new contribution would be allocated to bonds. That would leave $2,886.40 to be added to the stock fund. At that point, the stock and bond funds would represent $6,186.40 and $2,173.60, respectively.

One practical point to note is that this example presents a level of precision that is really unnecessary. Your account at any point in time can stray, with a bit more or less in bonds, and still do the job, for example, you may want to adjust your percentage allocation every five years. What is important is that the ratio of stocks to bonds declines over time such that the portfolio is more heavily invested in bonds as retirement approaches.

In the third year, the target ratio would be 27% bonds and 73% stocks and that year’s contribution would be allocated so as to achieve this overall ratio.


This process would continue year after year. For the first few years, all of the needed allocating is likely to be doable with fresh money. Eventually, however, the amount in the account may grow so large that, even if all of the new contributions were allocated to the underweighted component, the desired stock-to-bond ratio would not be achieved. Thus, in a later year, a strong overall stock market performance may cause the stock portfolio to grow by say 20% while the bond component would rise much less. Or, the stock portion may decline substantially while the bond fund holds its value.

In either of these circumstances, maintaining the desired ratio may require some rebalancing. If the bond (stock) component is significantly underweighted, selling some of the stock (bond) fund and buying of more of the bond (stock) fund may be required. In the later years particularly, the portfolio will need to be rebalanced toward bonds. But note: You do not need to rebalance more than once a year, and you should do any rebalancing in a tax-efficient manner if your funds are not in a retirement account.

Potential Savings

Let’s now compare the outcomes from the two (target date fund and do-it-yourself) approaches.

Historically, stocks have tended to generate a return of around 10% and corporate bonds around 6%. If the future is to be like the past, a blend of stocks and bonds such as the one we are discussing should generate a gross long-term return of around 8%. The target date fund’s gross return is likely to approximate the blended return earned by the two funds (stock and bond) that the individual would have chosen. But if the target date fund would incur an additional cost of approximately 1% in fees and expenses, its long-term net return would be reduced to 7%.

How much difference does that one percent of return make?

Assume one starts the program at age 25 and continues it until 65 (40 years), contributing $4,000 a year to the account. At a 7% rate of return, the account would grow to $798,520. At 8%, in contrast, it would grow to $1,035,620, a difference of $237,100. Thus, you could potentially increase your nest egg by more than a fourth by being a do-it-yourself investment manager, or by selecting a target retirement fund with very low expenses.

What kind of annual income would that savings buy?

You can get an estimate by comparing the amounts you could receive from a life annuity (immediate annuity) purchase. Such an annuity would provide an income whose payments would continue as long the person lived (although there are many other kinds of contract options). The size of the payments in relation to the amount purchased would depend upon the person’s gender, age and state of the market when the policy was purchased.

In the present market conditions, such annuities for a newly retired person (male, age 65) would provide an annual income in the range of 8% of the amount purchased. Thus, one could buy a lifetime income of $80 per year for each $1,000 of annuity purchased. In the above example, the smaller sum (about $800,000) could buy a lifetime income of around $64,000 whereas the larger sum (about $1,040,000) could purchase a lifetime income of more than $83,200.

So, again, we see how much difference that extra one percent of return makes. The do-it-yourself approach achieves almost $20,000 more in retirement income in this example.

Here are some important points to keep in mind if you are going to use this approach:

  • Use low-cost index funds for both your stock and bond portions. The do-it-yourself approach will not save you any money if the underlying funds you are investing in are costly.
  • Make sure the stock index fund (or funds) you use covers a broad-based index, such as the S&P 500 or, even better, the Wilshire 5000.
  • Make sure that the bond index fund you select covers a high-grade bond index (investment-grade or better) of intermediate-term or longer maturities.
  • Don’t worry about pinpoint precision when making your annual allocation determination. More important is the trend of the ratio of stocks to bonds should decline over time, such that the portfolio is more heavily invested in bonds as retirement approaches.

It doesn’t take a lot of difficult work to adopt the do-it-yourself approach to target date investing. The index funds do all of the actual selecting, buying and selling of the individual stocks and bonds. All you need to do is to allocate each annual contribution and occasionally rebalance to keep the portfolio in line with our formula. And with a little bit of effort, you can potentially end up with a substantially greater retirement nest egg and retirement income.

This article was written by Ben Branch for the September 2008 issue of the AAII Journal. At the time, Branch was a professor of finance at the Isenberg School of Management at the University of Massachusetts, Amherst. He is also an expert in bankruptcy investing, bankruptcy management, and valuing distressed assets.


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