Target-date retirement funds are pretty conservative, designed not so much to make you rich as to keep you relatively safe. Comfortable, but too cautious for many younger investors especially.
These funds typically invest workers’ money in a portfolio largely dominated by U.S. large-cap blend funds and (as time goes on) more and more income funds.
The result is little exposure to some of the most productive asset classes.
In Vanguard’s Target Retirement 2055 VFFVX, +0.33% , for example, 92% of the portfolio stocks are giant-cap, large-cap and midcap. Small-cap value stocks, arguably the asset class with the best long-term returns, account for just 3%
This is too bad, because this fund is aimed at workers planning to retire 40 years from now, investors who can and should take some additional risk, as long as that’s done carefully and thoughtfully.
The greatest attraction of target-date retirement funds is pure simplicity: one decision, one result.
But could young investors intelligently “turbocharge” such a fund with just one additional decision?
To test this, I created a hypothetical person in her mid-20s who invests $5,000 every year for 40 years, then retires and lives for an additional 25 years.
Let’s call this hypothetical person Jessica. Since I’m making her up, I’ll give her three choices:
- Jessica can put the entire $5,000 a year into the Vanguard target fund and be done with it.
- She can put 25% of each year’s investment into a small-cap value fund or ETF and the rest in the target fund.
- She can direct 40% of her money to small-cap value stocks.
This is a simple choice for Jessica, but one that could have enormous financial consequences for her.
Using conservative assumptions I am quite comfortable with, Jessica could more than double her lifetime return by taking that third option of a 40% allocation to small-cap value stocks.
The hypothetical results of Jessica’s three choices are summarized in the table below. Here are the high points.
1. Target fund only: With this option, assume Jessica can expect a compound return of 8% before she retires. The fund’s return will be lower after retirement; I’m assuming 6%.
After 40 years her fund would be worth $1.3 million. Her first-year retirement withdrawal would be $51,811 (based on taking out 4% of the portfolio value).
In 25 years of retirement, Jessica will have taken out $1.71 million. If she passes away after 25 years, her estate will be worth $2.43 million.