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How to double your target-date retirement fund’s return in a single move

Reprinted courtesy of MarketWatch.com.

To read the original article click here

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.

2. Put 25% into small-cap value: In the second option, Jessica has a good shot at a pre-retirement return of 9.5%, a big boost over 40 years. (I base this on the assumption of a 12% long-term return on the small-cap value part of her portfolio.)

She’ll have $1.93 million when she retires, and her first annual withdrawal will be $77,213 — around $25,000 more than she would get with the 100% target-fund option. Assuming her after-retirement return is 7%, Jessica’s total of 25 payouts will be just shy of $3 million, and she’ll leave an estate with a value approaching $4 million.

3. Put 40% into small-cap value: If Jessica takes the third option, she will do considerably better. Her annualized return could be 10.2% and her portfolio value at retirement could be $2.31 million.

She will start her first year of retirement with $92,454. Assuming she gets 7% after-retirement returns and takes out 4% a year, 25 years of withdrawals will total $3.58 million, leaving an end-of-life estate worth $4.5 million.

The last line of the table below shows that her total lifetime return (withdrawals plus her estate) is more than twice as great if she chooses to invest 40% in small-cap value starting when she’s young.

These scenarios are not perfect, and probable inflation will mean Jessica won’t be as flush as the numbers might suggest.

Assuming long-term inflation of 3%, that first-year distribution of $51,811 would be worth $15,321 in today’s dollars. (Still, that’s more than three times the real value of the dollars she invested in her first year.)

In the most aggressive scenario I’ve outlined, her first-year distribution would be worth $27,339 in today’s dollars, and her presumed end-of-life estate $668,281.

Those numbers fall far short of the stratosphere, but they are far better than the projected results from only the target-date fund. And while we’re facing reality, it’s important to note that this is not the whole picture.

It’s highly likely that Jessica will set aside more resources than just the $5,000 I have described. She may have a 401(k) with an employer match. She may have a spouse who also invests.

On one level this is little more than a compound-interest-table exercise. As any mathematician knows, if you make enough assumptions, you can produce amazing hypothetical results.

The numbers in the table below are not facts. We can’t know future inflation, future investment returns, or future economic realities.

But those numbers show that saving and investing methodically over a long period is likely to multiply the real value of each dollar set aside. They show that supplementing a target-date retirement fund can greatly improve an investor’s long-term returns.

For more, check out my podcast “Eight ways to make more money in your target-date fund.”

Invested in small-cap value025%40%
Pre-retirement growth rate8%9.5%10.2%
Value in 40 years$1.3 million$1.93 million$2.31 million
1st year payout$51,811$77,213$92,454
Total of 25 annual payouts$1.71 million$2.99 million$3.58 million
Value after 65 years$2.43 million$3.94 million$4.5 million
Total initial investments$200,000$200,000$200,000
Lifetime return$3.84 million$7.03 million$8.41 million

Richard Buck contributed to this article.