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The glide path
How to reduce risk
Are Target Retirement Funds only for retirement?
Simplicity
What's in it? A British twist...
What happens on the target date?
Low fees
More than one?
Alternative Target Date Funds
A bit more sophisticated: risk capacity
Conclusion
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Vanguard Target Retirement funds are inexpensive, diversified and designed to give you a good, but not guaranteed, investment outcome by some fixed date in the future. They do this by starting with a high equity allocation then dialling down risk by moving more money into bonds as the fund approaches its target date. These funds would suit people who want to invest for some fixed expenditure at a known time in future such as retirement, but also things such as their child's university expenses or a deposit to help their children get on the property ladder.
Vanguard Target Retirement funds do not offer any guarantee that they will meet some target return by their target date. However by controlling risk they increase the likelihood that you will get good returns over their investment horizon. So how do they work?
The glide path
Investments look completely different depending on the period of time you invest. If you invest in a US stock index for one week it's almost like tossing a coin, there's a roughly 57% chance that you make money and 43% chance that you lose money. If you invest in the US stock index for, say, 40 years historically you would always have made a positive return. As you dial up the investment horizon from one week, to three weeks, to one year, then ten years and forty years in the graph below see what happens to the return you make:
- Your investment return was more likely to be positive
- Your investment return became more certain
Often you'll hear grizzled investors say that you "have to look through the volatility". What they mean is that if you buy a stock index, ignore the financial news and wait for a very long time without buying and selling you will probably make reasonable returns.
- The Mayfly and Methuselah
Unfortunately we can't control the timing of our investments because the time when we start saving and when we retire are determined by our birth date. If our daughter is ten years old and we're saving for her to go to university then we have nine years. If we're fifty and we're saving for retirement at sixty six then we have sixteen years. But from the graphs above we can see that if we have a shorter time to invest we should take less risk.
Here's my personal timeline. I was born in 1968, an event over which I have no control. That meant I started earning money when I was about 20 in 1988. I will retire at age 67-ish in 2035 and I'm likely to live to the age of 86. That means I have to support myself for 17 years with the money I've saved since I was 20. The idea is that I would pay into the 2035 Target Retirement Fund until I'm 67. Then, if I choose to stop working, I can sell bits of my fund to pay my living expenses until I die.
How to reduce risk
The risk in a portfolio is dominated by shares because their prices usually fluctuate more, or are more volatile, than bonds. If we want to reduce risk, but still earn a higher return than cash, we would buy bonds. So as we grow older it might make sense to reduce the percentage of our portfolio in shares and move it into bonds. This is the essence of Vanguard Target Retirement Funds.
This graph from Vanguard shows the percentage of their Retirement Fund that is invested in shares (equity) and bonds against age. Until our mid-forties the fund keeps 80% invested in equity, then starts to cut back to 50% equity at around retirement age and this falls more steeply to 30% equity from 75 years of age onwards.
Are Target Retirement Funds only for retirement?
No!
There may be many times in the future when we know we will need to draw on our savings and retirement is just one of these. In the introduction we mentioned others based on the needs of our children (university, first house deposit). Some are a bit more uncertain. For example can we guess when (or if) our children will get married? If so it might make sense to invest for this happy, but somewhat fraught, future date.
But the point is that Target Retirement Funds are not only for retirement. They might be better branded as Target Date Funds.
In fact, you can use target date funds to build your own cheaper version of a robo fund like Nutmeg and Moneyfarm. To learn more here's our course:
- How to Create Your Own Cheap Robo Fund
Simplicity
The alternative to Target Retirement Funds would be to invest in funds ourselves. This introduces a lot of complexity. Now, as an investment nerd, this is the kind of complexity which I personally prefer. It involves the following:
- Asset Allocation: Decide on a share/bond split in my portfolio that fits my risk appetite, investment horizon and my view on the relative attractiveness of each market.
- Regional Allocation: Once I've decided my asset allocation I'd then think about which regions are most attractive given the macroeconomic state of the World. Is Asia more attractive than Europe, or is the US looking best?
- Diversification: How can I choose my portfolio allocations to best diversify my portfolio? This depends on the correlation of returns across assets.
- Rebalancing: Once I've built my portfolio it has to be maintained. As asset prices move the portfolio may drift from my strategic allocation. In this case I have to occasionally rebalance the portfolio to bring it back in line with my long-term goals.
Target Retirement Funds remove all of this complexity. All you have to think about is when you need the money. The key question you have to ask is whether you trust the creator of the fund to build the "right" portfolio to suit your goals. Maybe you think there's an opportunity that the fund is missing? If this is the case you can always hold some money outside the Target Retirement Fund to invest in any such fund or asset. But this detracts from the key design principle of these funds: simplicity. For the vast majority of people simplicity is probably best.
What's in it? A British twist...
For the UK version of the Target Retirement Funds the portfolio has been tweaked to be more appropriate for UK investors. The glide path still dials down the risk as the fund's target date approaches, but the precise composition of the fund is different to the US version. UK investors will invest in sterling and so take no currency risk if they buy UK stocks and bonds. UK markets for stocks and bonds are much smaller than those in the US, so inevitably UK investors wanting a diversified portfolio that reflects market size rely more heavily on "foreign" assets.
Initially the funds are dominated by equity and the purple swath shows the allocation is mostly in global ex-UK equity shares. As the fund draws nearer to the target date the proportion of shares decreases and the proportion of bonds increases. The bronze colour at the top representing global ex-UK bonds now starts to dominate. These foreign bonds are currency-hedged. The reason for this is that bonds are intended to reduce the risk of this portfolio. The currency risk of sterling would swamp the relatively small risk of bonds so the fund buys insurance to get rid of the currency risk just as if US bonds were bought in US dollars and European bonds were bought in euros. The fund will pay for this insurance but Vanguard obviously considers this a worthwhile cost.
After the age of 70 the fund has a significant amount, almost a fifth, in inflation-linked bonds. This provides protection of capital if inflation surges. Inflation is a risk because the cost of goods and services can increase and erode the value of your investments. Shares provide a limited level of protection against this because companies can raise the price they charge but this protection fails if inflation is too high. Inflation-linked bonds provide a much more reliable form of protection against inflation.
- What is Money Illusion?
- Why inflation is sexy
- Video on Inflation-Linked Funds
What happens on the target date?
Nothing.
The portfolio continues to adjust according to the preset glide path which stops changing at age 75 about seven years after the target date. You certainly don't have to sell the fund on the target date. You can sell some or all of your Target Retirement Fund at any time, but the glide path is tuned so that the best time to start to take money out is after the target date.
Low fees
As with any Vanguard fund the fees for Target Retirement funds are extremely competitive. The figure that investors usually use to gauge cost is the Ongoing Charges Figure (OCF). However under new legislation called "MiFID II" the total cost of owning a fund now has to be published and this breakdown is more detailed. This must also include an estimate of transaction costs, which is the amount the fund pays to buy and hold assets held within the fund, also account fees and one-off costs such as entry fees for example.
Ongoing charges for each target fund are shown below in blue and this component dominates the total cost of owning Vanguard Target Retirement Funds and is 0.24% per year. Account fees add 0.15% per year and transaction costs start at 0.11% for the 2015 fund and fall to 0.09% for the 2065 fund. In total that means a cost of 0.48% to 0.50% per year. On a £10,000 investment that would be a total fee of £48 to £50 per year which compares very favourably with other target date funds specifically and multi-asset funds generally.
Transaction costs are quite different from the other two costs because they will never appear on an itemised list of charges from Vanguard. Instead these will reduce the return on your fund, so in this sense they are "invisible". They are also difficult for a fund manager to calculate because trading activity is driven by markets. If markets move more then the fund has to rebalance more frequently, and as markets are unpredictable the exact transaction cost is also unpredictable. However, from an investor's point of view it is very useful to have this new level of transparency.
More than one?
What if you have more than one event in future when you know will need to draw on your savings? There is no limit to the number of Target Retirement Funds which you can own. So it is possible to hold a fund for your children's university fees and another for your own retirement. In fact there is an approach to investing pioneered by Harold Evensky. He says that you should never invest money that you will need in less than five years, so you keep money in "buckets".
- Cash Bucket: Use this bucket to live off and for emergencies when you need money immediately. Cash would also include short-term bonds that carry very little risk. The return on money in this bucket will be very low, particularly as interest rates are very low at the moment.
- Investment Bucket: This is for longer-term savings of five or more years. This is going to contain more risky and potentially higher return assets i.e. more shares.
Essentially the Target Retirement Funds could act as your buckets. You could have one bucket for your children's needs as they grow up another for a future house "upgrade", another for retirement...
- The Bucket Approach to Retirement Allocation by Christine Benz of Morningstar
Alternative Target Date Funds
In the UK some target date funds are available to companies when choosing their pension fund providers but not directly available to normal investors. The offering looks quite thin when searching on Morningstar for Target Date Funds 2020-2025 (click on the image to see for yourself or look for other target date ranges):
The fees for Vanguard certainly look competitive based on the ongoing charge column against the alternatives of Architas BirthStar and Fidelity. The other alternative is to build your own Target Date fund using ETFs. For example you could start off as a young person with the Vanguard 100% equity LifeStrategy fund then switch into 80% equity 20% bond LifeStrategy as you get older, gradually shifting your risk gear down to 40% equity 60% bonds. This would match the glide path of target date funds fairly well. But this would require strict discipline in keeping to the glide path and the added flexibility may not warrant the extra effort. The time investment is beyond most people who want to live their lives without worrying about whether their portfolio weights are on the glide path.
A bit more sophisticated: risk capacity
Greg Davies of Oxford Risk suggests that we should take a slightly more dynamic and tailored approach to risk based on a combination of risk tolerance and risk capacity. For example if we add up our total list of assets including our property investments, our art collection, our vintage cars, then we might get a very different picture of our risk capacity. Here is Oxford Risk's definition of risk capacity in a blog:
Risk Capacity is the extent to which an individual can cope with potential losses, having considered their financial circ*mstances and the aims and aspirations that comprise their investment objectives. It differs from risk tolerance in that the ‘coping’ in this case is not only subjective and figurative, but tangible; “How much can you really afford to lose”, or, to put it as an upside, “How much can you really afford not to gain”Andre Correia, Oxford Risk
As a person ages they may accumulate enough wealth that the standard glide path is not applicable because they could quite easily ride out a fall in their investments while carrying on with their life meeting their costs quite comfortably. If that is the case their glide path may look more like this:
Notice that after retirement the glide path of this individual actually increases. This is because for this individual (not necessarily you or me!) they have enough assets to cover the costs of their remaining life. As they grow older their costs diminish as their life expectancy diminishes. To hear Greg's excellent presentation which explains these ideas in more detail take a look at this video from the Humans Under Management conference (you will see the graph above 31 minutes into the video):
Conclusion
Target Date funds, and Vanguard's Target Retirement Funds, offer a simple way for anyone to save during the course of their lifetime. Vanguard's obsession with keeping fees as low as possible ensures that any returns you receive over the decades during which you invest are not gobbled up by your fund manager.
To get the best out of target date funds you have to be disciplined, saving a regular amount over a very long period of time and not withdrawing any of that money if at all possible. Because target date funds always keep a fixed date in mind this helps reduce our "tendency to tinker" which often erodes the value of investments. The funds offer no guarantee we will meet any long-term return target but they provide a good shot at squeezing a reasonable return out of markets during the course of our lives.
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