(Jarrad sniffing)
- Smell that?
It smells like trash.
I mean, target-date funds.
I mean, hey friends, how's it going?
In this video, we need to talk about
why you definitely want to avoid investing
in target-date retirement funds if you're someone
who is working towards financial independence.
To be honest, even if you aren't interested
in financial independence,
a target-date fund is probably something
you wanna reconsider putting your money into
because it can hurt your returns more than it can help.
Look, are TDFs as horrible of an option
as something like an ARKK ETF?
Absolutely not.
But TDFs are definitely not an optimal investment
because you can do a lot better
and I'll give you an example of how.
All the target-date fund is
is an investment vehicle
that automatically puts your money
into a mix of stocks and bonds
based on the year that you plan to retire
Think of a TDF like a fund of funds
because instead of directly holding
individual stocks and bonds,
they'll just go out and buy different indexes
that already hold those investments.
As time goes on,
the fund will automatically adjust
your stock and bond allocation
as you move closer to the specified retirement date.
This is sometimes referred to as a glide path
because you're most likely going to be investing differently
when you're 40 years from retirement
compared to when you're five years from retirement.
Most big investment companies offer TDFs:
Vanguard, Charles Schwab, BlackRock,
and others call them target-date funds
or target retirement funds
while other companies like Fidelity call them Freedom Funds.
Vanguard's website makes it pretty easy
to get an idea of which one you'd wanna choose.
They give you a birth year
and the number of years to retirement,
which helps make the decision process a whole lot easier.
Most of them will assume
that you'll retire between the age of 62 and 67.
Well, this does seem helpful.
It is one of the biggest problems with a target-date fund,
but more on that in a minute
because we need to first understand
why this type of retirement investment vehicle
has become so popular over the years.
I'm specifically going to be picking
on Vanguard TDF this video for all of my examples,
but everything that I say
basically applies to target-date funds as a whole.
I usually speak very highly of Vanguard in this channel.
And because of that, a lot of people probably think
that I'm a show for the company.
So, hopefully, this changes their mind.
One of the main reasons a target-date fund
has become so popular
is because they're very accessible
within retirement plans through employers.
80% of 401k plans offer a TDF
and 24% of all assets within a 401k
are invested within that type of fund,
which is the most of any investment option held
within that type of account.
They're also extremely easy to understand.
Here's my age, here's a retirement date,
that looks close enough,
so I'll put my money into this TDF and forget about it.
Investors who know very little about investing
find comfort in a one-stop solution
because it's less to learn and manage,
the path of least resistance.
Target-date funds are the default investment option
within a 401k.
So, if someone forgets to log in and make any changes,
money is automatically going to be invested,
which can sometimes be a good thing
for the people who were never gonna check it anyways.
If you like dogs, then my pup Molly would love it
if you hit that thumbs up button
to help support her passion for the great outdoors
because more likes equals more hikes for her.
But the target-date part of the fund
is one of the main drawbacks to this type of investment
if you're pursuing financial independence.
People in the FI community
are definitely nerdy overachievers,
which means that they wanna have
the ability to retire a lot sooner
than the assumed age of 62 to 67.
Because of that, the FI person's investing strategy
is going to be a lot different
than the average retirement person.
Think of someone working towards financial independence,
like a sprinter
and the average person on the normal path to retirement
at the age of 65 as a long distance runner.
There's, of course, going to be some overlap
in their training plan.
But for the most part, those two types of people
are going to be training in completely different ways
to optimize for their end goals.
Even if we're talking about the average investor,
I still think that a target-date fund
could potentially hurt more than it helps.
And that's because the investing style
is based on the end goal
without taking into account
where the person is at financially right now.
Probably one of the biggest issues
that I see with target-date funds
is the fact that they have way, way,
way too much money invested into bonds
for younger investors.
By way too much, I mean anything greater than zero.
For the first 25 years,
a TDF has the investor hold an average of 10% of their money
in bonds every single year.
So from the age of 19 to 44,
the breakdown is about 90% in stocks and 10% in bonds.
10% doesn't seem like a lot,
so it can't really make that big of a difference, right?
Well, let's back test two different portfolios
to find out what the opportunity cost
of holding a 90/10 allocation
versus a 100% stock allocation for 25 years
would have been starting with 1997 and going through 2021.
I have to mention this before the weirdos out there
start rage typing in the comments about technicalities.
Past performance does not dictate future returns,
so take the numbers that I give you with a grain of salt.
This is to give you a general idea
of how much being too conservative when you're younger
could cost you.
If you invested $500 per month into each portfolio,
then after 25 years,
the 100% stock allocation
would have returned at 9.3% annually
and would be worth about $832,000.
While on the other hand, the 90/10 portfolio
would have an average annual return of 8.23%, so 1% lower,
and it would be worth $693,000.
If you're like me and don't do public math,
that's a difference of a $138,000
or 9,200 five-pound bags of a gummy bears on Amazon,
which, oddly enough, equals 46,000 pounds of gummy bears.
That's a lot of gummy bears.
Now, if you said, "Hey, I'm gonna continue investing
that $138,000 into 100% stocks for the next seven years
and I'm going to expect a measly 7% average annual return."
Then that amount would grow to...
Wait for it.
I'm kind of afraid to show you this number
because it's a lot: $534,000.
I'm not even gonna bother doing
the gummy bear equation for you.
Because at that point,
you could probably just use that money
to start your Willy Wonka empire.
- The snozzberries tastes like snozzberries.
- When you were younger,
you can afford to take more risk
by investing in 100% index funds
because you have a lot more time to allow your portfolio
to recover when those down years in the market come around.
Target-date funds are way too conservative.
I'd even go as far as saying
that they continue to be too conservative
by increasing your bond allocation too much, too quickly
as you get closer to the target retirement date.
Heck, at 18 years from the target retirement date of 2040,
they have you in 19% bonds.
If you're someone who is behind on investing,
then limiting your upside with 19% bonds
is absolutely bananas.
If you enjoy burning through a half a million dollars,
then that's on you.
But another reason target-date funds
aren't good for my financial independence people
is because you're paying more for them
than you actually need to.
Anyone who has been in the FI community for long enough
knows that keeping costs low is extremely important
and in the end, will help you reach FI a lot sooner.
For Vanguard, specifically, they charge anywhere
between a .12 and .15% expense per year.
Let me be clear so I don't sound like a butthead.
Those fees are already extremely low as it is.
And technically, Vanguard's fee
is lower than the .55% industry average.
But if we can save some money
by building the exact same portfolio on our own,
then we need to do that.
And if you have a TDF
with anyone that charges more than .12%,
then they're basically laughing in your face
while, at the same time, pickpocketing you.
A target-date fund is basically made up of four things:
a Total US Stock Market Fund,
Total International Fund,
Total US Bond Fund,
and Total International Ex-US Bond Fund.
It's essentially a four-fund portfolio,
pretty close to the three-fund portfolio
that I made a video on that I love,
except that the TDF has international bonds in there.
I would even argue that you could probably do
without the International Bond Fund
and just stick with a US Bond Fund instead.
But that's another conversation for another day.
Since we know what's inside the TDF,
you can pick those exact same funds on your own
and bypass them doing the work for you.
Like I said, they're going to charge you
anywhere between .12 to .15% for this work.
While if you pick the funds individually on your own,
then it would only cost you a total of .06%.
That's a savings of anywhere between 0.07 and 0.09%.
Is this amount going to make or break
the future value of your investments?
Absolutely not.
But why pay more for a worse product
when you can do it yourself
and it'll probably take you five minutes of work?
If you are on the path to financial independence
and max out all of your tax advantage accounts,
then the only place left to put additional money
is in a taxable brokerage account.
And putting a target-date fund into that type of account
is very tax inefficient.
The target-date fund's main goal
is to maintain a particular asset allocation
even if doing that is very tax inefficient for the investor.
So, the 2045 Target-Date Fund
is only worried about keeping the stock allocation at 88.6%
and the bond allocation at 11.4%.
Because of this,
if the stock allocation happens to grow to 90.6%
and the bond allocation drops down to 9.4%,
then the TDF needs to sell off 2% of its stock allocations,
so it can buy 2% of the bond allocation
to get back to that 88.6 and 11.4% target allocation.
It doesn't sound like a big deal, right?
Rebalance a little bit here,
rebalance a little bit there.
Oh, but there's a problem.
If the stock allocation increased,
that means that there must have been gains
within the funds somewhere.
When those stocks are sold at a profit to rebalance,
the fund is locking in those capital gains,
which is a taxable event in a taxable brokerage account.
And guess who has to pay those taxes?
You as the person that owns
that target-date retirement fund,
I double-checked Vanguard
and it looks like they rebalance daily,
so you could be incurring capital gains taxes
multiple times throughout the year
and not even realize it until you go to file your taxes.
To make matters worse,
after the initial 90/10 allocation for the first 25 years,
a target-date fund
starts rapidly selling off your stock funds
to buy bonds every five years.
And every time it does this, that is a taxable event
if your stocks have grown,
which, they probably have
because that's the whole point of investing in them.
You go from 88.6% stocks in 2045 to, five years later,
having to sell off 7.6% of them
to buy the no growth bonds to reduce volatility,
even though you're still 18 years for retirement.
Oh, and do you have to pay taxes on the stock gains.
This continues every five freaking years,
slowly destroying portfolio growth
until you hit the target retirement date,
and then they have you allocating 54% to bonds
and 46% to stocks.
It's almost like they don't even wanna give your portfolio
a chance to grow when you're in retirement
even though you still need to see gains
within your portfolio
to be able to continue to live off of that portfolio.
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on the path to financial independence.
Watch these videos to your left next.
I'll see you in the next one, friends, done.