How Does a Target Retirement Fund Actually Work?

Tim writes in:

Question for the Mailbag: how exactly does a target retirement fund actually work? Every time I read about it it makes less sense.

This did start off as a question in the mailbag, but the answer became so long that it seemed sensible to give Tim’s question its own article.

Let’s start off talking about risk and reward.

There are a ton of different investment options out there. They differentiate themselves in a bunch of different ways. Some are really low risk, but don’t offer much return, like a savings account. Even in the best online savings account, you’re going to earn only 1% to 2% a year, but there is essentially zero chance of losing money.

Over the course of 10 years, an investment like this might see returns each year of 1.5%, 1.5%, 1.5%, 1.5%, 1.5%, 1.5%, 1.5%, 1.5%, 1.5%, and 1.5%, giving an average of (you guessed it) 1.5%. While the average is pretty low, notice that there is no individual year where money is lost. There is no time in which it is “bad” to have to rely on your investment, because this investment is as reliable as can be.

As you start adding risk, you generally start adding more return, like, say, VBTLX (the Vanguard Total Bond Market Index Fund), which offers a better average annual return (around 4%), but has a chance of losing money in a particular given year.

Over the course of 10 years, an investment like this might see returns each year of 4.5%, 3.3%, 4.8%, 4.9%, 4.5%, 4.3%, -0.5%, 4.7%, 4.8%, and 4.7%, giving an average of 4%. The annual returns are fairly consistent, but note that -0.5% year. In that year, the investment lost money, and there will definitely be years like that over the long haul.

Those lower-than-average years – and particularly those losing years – are problematic. Let’s say you’ve had a run of above average years and you’ve decided you have just enough money in your investment to make retirement work. Then, as soon as you retire, that investment spends the next year losing money, throwing off your math entirely and making retirement look real dicey. While it’s not too bad in the case of this investment, the riskier you get, the more likely this scenario is to happen. Those year-to-year variations are often referred to as volatility – an investment is volatile if it has a lot of those variations.

Let’s add some more risk and look at the Vanguard Total Stock Market Index (VTSMX). It has an average annual return since inception of 9.72%, which seems sweet, right? Let’s look closer.

Let’s look at the last 10 years of annual returns for it in reverse order: 21.05%, 12.53%, 0.29%, 12.43%, 33.35%, 16.25%, 0.96%, 17.09%, 28.70%, and -37.04%. Three of those ten years are worse than a savings account. One of them involves losing more than 37% of your investment.

This investment is even more volatile. Consider that you’re just starting your retirement and you have your money all in this investment and you hit one of those 40% loss years. That’s going to change the math of your retirement drastically. You’ll be pulling money out to live on as the market drops, which means that you will have depleted a much higher percentage of your retirement savings than you should in a single year and you’ll probably have to do that for the next two or three years while you wait for the market to rebound. This leaves you with a permanently depleted retirement savings, which either means very lean living late in life or a return to the workforce.

Want to see what that looks like in numbers? Let’s say you have $1 million invested in this and you retire, deciding to withdraw $50,000 a year to live on. That’s 5% a year, which is pretty risky, but you believe in that long term average return. Well, during the first year, the investment loses 40% of its value. It drops to $600,000… but you took out $50,000 to live on, so it’s actually just $550,000. Going forward, if you take $50,000 a year out of that, you’re going to go bankrupt in about 15 years (if not sooner, depending on volatility).

You can keep adding more and more risk and get a higher average annual return, but the key word here is average. You can look at things like the VSIAX (the Vanguard Small-Cap Value Index Fund), which has a very high average annual return but is primed to take an absolute beating the next time the stock market declines, meaning it’ll lose a large percentage of its value as those businesses struggle during an economic downturn (causing some investors to sell) and other investors flee to safer investments. You eventually reach investments that are tantamount to gambling, like cryptocurrency, which is so volatile that you might triple your investment or lose half of it in a month or two.

Related: Why You’re Guaranteed to Lose Money in the Stock Market

So, what’s the message here? If you have a lot of years before you retire, you want your money in something pretty aggressive that has really good average annual returns, but might have a few individual years that are really rough. If you don’t need the money anytime soon, those individual bad years don’t really matter to you – in fact, they’re kind of a blessing for you because it’s cheaper to buy into an investment when the market is down.

As you start getting close to retirement and actually retiring, those individual years start to become much more important. Unless you have a very large amount in your retirement account, you can’t afford one of those big down years that are somewhat likely to eventually happen with an aggressive investment. If it happens, you’re going to be right back in the workforce.

The solution, then, is to be aggressive with your retirement investments when you’re young and then, when you approach retirement, move your investments to less aggressive and less volatile investments that you can rely on more.

The best way to start understanding what a target-date index fund does is to look at some people who are on the road to retirement.

Angie is 25 years old. She’s not intending to retire for 40 years. Because her retirement is so far off, she can afford quite a lot of risk in her retirement savings. She can afford to invest in things that have a pretty good average annual return that’s paired with the risk of enormous loss. She might put her money into the Vanguard Total Stock Market Index and/or the Vanguard Small-Cap Value Index Fund. Her goal is to build as much value as she can over the next 40 years and chasing a high average annual return is the best way to do that.

Brad is 45 years old. He’s not intending to retire for 20 years. He’s probably still going to be pretty aggressive, but the idea of going less volatile might start popping up in his head. He still wants a very high average annual return, but there will come a point soon where he needs to make some changes.

Connor is 60 years old. He’s thinking of retiring in five years. He’s got almost enough to retire in his retirement savings. At this point, he really can’t afford to have everything in an aggressive investment that might drop 40% of its value. So, he might leave some of it in stocks, but the rest might be moved to bonds. His average annual return might be lower, but he’s no longer running the risk of losing 40% of his entire retirement savings.

Dana is 70 years old. If her retirement savings keeps growing in a slow and stable fashion, returning just a few percent per year but not losing a bunch of value in any given year, she’ll be fine. She probably wants to be mostly in the Vanguard Total Bond Market Index and maybe even have some in a money market fund (akin to a savings account with very little risk).

As you can see from these stories, as you get older and closer to retirement, it makes a lot of sense to gradually shift your investments from highly aggressive investments to more conservative ones. The issue, though, is how does one know when to start making those transitions? Furthermore, will you remember to do it, and to do it right? Those aren’t easy questions for individuals saving for retirement. It’s not entirely clear when to do this or how to do this, and many individuals aren’t going to put in the research and time to do it. People just want to put away the money and then have money when it’s time to retire.

That’s where target retirement funds come in. They do this automatically.

Let’s look back at 25 year old Angie. She aims to retire in about 40 years. So, theoretically, she wants to choose a pretty aggressive investment to put her retirement savings into. However, when she’s in her late forties or early fifties, she might want to begin slowly making things more conservative, and this gets even more true as she reaches retirement age and then retires. She doesn’t want a nasty shock when she’s old.

That’s what a target retirement fund does automatically. If Angie is 25, she’s going to retire sometime around 2060, so she might buy into a Target Retirement 2060 fund with her retirement savings. Right now, that target retirement fund will be really aggressive, but as the decades pass and the 2040s arrive, it’s going to slowly become less aggressive, and in the 2050s, it becomes even less so. It cuts out the volatility in exchange for a lower average annual return as it gets closer to its target date.

How does it do that? A target retirement fund is just made up of a bunch of different funds, and as time passes, the people managing the target retirement fund slowly move money out of some of the funds inside of it and move it into other funds.

So, for example, a Target Retirement 2060 fund might today be made up of 50% VSIAX and 50% VTSMX – in other words, it’s really aggressive, entirely invested in stocks, and some of those stocks are small companies that will either grow like gangbusters (big returns) or flame out (big losses). That’s okay for now – volatility is completely fine when you’re that far from retirement. What you want is a big average annual return over the next 25 years or so.

However, at some point down the road, probably in the mid-2040s, that fund will start becoming less aggressive. The money within the fund will be moved by the fund managers into things like bond funds or real estate, things that don’t have quite so high of an average annual return but aren’t going to see years of big losses, either.

By the time 2060 rolls around, all of the money in that fund will be in pretty safe stuff, which means you can rely on that fund to be stable in retirement.

That’s what a retirement fund does: It’s made up of a bunch of different investments that are gradually moved from highly aggressive things to less aggressive things as the target date approaches. When the “target” year is many, many years in the future, the fund will be really aggressive and really volatile, aiming for big returns over the next two decades at the cost of some really rough individual years. As the “target” year gets closer and closer, the fund gets less and less aggressive and less and less volatile, becoming something you can rely on.

That’s why, for people who aren’t really involved in managing the nuances of their own retirement savings, a target retirement fund with a target year pretty close to their retirement year is a really solid choice. It just manages that gradual shift for you without you having to lift a finger.

Good luck!

More by Trent Hamm:

The post How Does a Target Retirement Fund Actually Work? appeared first on The Simple Dollar.

Contributer : The Simple Dollar https://ift.tt/2Mmwjuc