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Target-date funds (TDFs) can be fantastic retirement savings tools. Many are well-diversified, cost-effective, and automatically reduce risk for investors as they approach retirement.
There’s a problem though. Most hold bonds in their early years when young investors are protected from portfolio balance declines by relatively large contributions to accounts with relatively small balances. They also rarely include meaningful amounts of small-value asset classes which historically have improved returns over the long haul.
To offset this over-conservatism, we proposed a simple solution: multiply the investor’s age by 1.5 and use that as a percentage to invest in a TDF, then put the rest into an all-equity fund. In backtesting, this approach outperformed a pure TDF approach in more than 99% of the 576 overlapping 40-year periods tested, and only increased dips in portfolio balances (drawdowns) by 2% to 6%. Here’s the summary data from that study. Please see that article for detailed descriptions.
That looks good for working years, but what about early retirees and people nearing or in retirement already?
For those planning to retire early, the answer is simple. Instead of using 1.5 times your age to determine the percentage you would invest in the TDF, you turn it around and use 1.5 times the years left to retirement to determine the percent you invest in the second fund. For example, if you are 30 years old and saving aggressively to retire at age 50, you are 20 years from retirement. 1.5 X 20 = 30, so you’d invest 30% in small-cap value (or other asset class of your choice) and 70% in the TDF.
How does that change the numbers? Because there are so many variations on the early retirement approach, it’s not practical to summarize them in a single table, but what we can say is that the same principles that make this strategy work for age 65 retirees should also help early retirees. The effect will be reduced because there aren’t as many years for compounding to work, but it’s still likely to help.
If you’re at or in retirement, it’s easy to feel left out. If age times 1.5 equals 100 or more, does that mean I should just be 100% in the target-date fund?
Here, It depends on whether you’ve under or over saved, and that depends on how much of your nest egg you need to spend each year in retirement.
Say you’ve got $1 million saved, have a cost of living of $50,000 a year and $10,000 a year in Social Security. You would only need to spend $40,000 from your nest egg a year, so your withdrawal rate is only 4%.
There’s been a lot of research done suggesting 4% is a safe withdrawal rate for retirement at age 65. If you plan to retire much earlier than age 65, you may need to use a withdrawal rate between 3% and 4% to make your money last.
So, if you’re retiring around age 65, and need more than a 4% withdrawal rate, we could say you’ve under saved by a bit. If you need less than that, then we could say you’ve over saved, And right around the 4% rate, we’ll call just right.
If you’ve under saved, don’t despair, but do see a financial planner.
There will be a path forward, but it’s more likely to require some creativity. It may involve working longer, lowering expenses, increasing savings rates, changing investment portfolios or other approaches. A good financial planner should be able to help you figure it out.
If you’ve saved just the right amount, congratulations.
The Two Funds For Life approach is fairly easy to extend into retirement for someone who has saved just enough because that’s pretty much what the target-date fund managers plan for. Sticking with a 100% allocation to the target-date fund in retirement is simple and prudent. It may err on the conservative side, but this may be what’s needed by retirees transitioning from regular paychecks to living off their investments. Once retirees are comfortable living off of their investments, it may make sense to shift back to a two-fund approach if they can tolerate a little more volatility. Monte Carlo simulations at www.portfoliovisualizer.com suggest, even at a 4% withdrawal rate, that a shift of 10-20% from a Vanguard-like target-date fund to an all-equity fund increases expected returns substantially and reduces the likelihood of running out of money.
If you’ve saved more than enough, you’ve got lots of options.
The simple way to think about your options is to assume that you have two buckets of investments. The first bucket is the part of your portfolio that you need to live on in retirement. This is the portion required to enable a 4% withdrawal rate. If you need to withdraw $5,000 a year to meet expenses, $1.25 million ($50,000 / 4% or 25 X $50,000) of your investments would be invested in your retirement portfolio. Investing this portion in a target-date fund is again simple and prudent.
Whatever you have beyond that can be invested more aggressively since it will likely be passed on to children and charities when you die. If you want to stick with a two fund solution, you could invest the “extra” in any one of the second fund choices modeled in the Two Fund for Life analysis. If you want more diversification, you could use multiple secondary funds to spread across multiple asset classes and geographies. Even adding a traditional balanced fund (i.e. 60/40 equity bond) will likely produce a meaningful additional return.
What can we expect from a two-fund solution in retirement?
If you’re in your working years, look at the table at the beginning of this article, and read the article it came from. That will give you a pretty good idea of what to expect. If you’re contributing regularly, you won’t likely see any big drawdowns in the early years, but they’ll get bigger toward the middle of your career and then decline approaching retirement.
If you’re nearing or in retirement, there’s good news. There’s a tool to help paint a picture of the range of outcomes you’re likely to experience. The tool is the Financial Goals page of the Portfolio Visualizer website. Here’s a table summarizing the final results for a $1 million starting balance over a 30-year retirement using all-target-date and two-fund allocations and an example link.
| 3% fixed withdrawal rate | 4% fixed withdrawal rate | 5% fixed withdrawal rate | |
| 100% in target-date fund | $0.8M to $3.5M | $0.05M to $2.4M | $0 to $1.2M |
| 90% in TDF, 10% in small-cap-value | $0.9M to $4.5M | $0.07M to $3.3M | $0 to $2.0M |
| 80% in TDF, 20% in small-cap-value | $0.9M to $5.8M | $0.1M to $4.3M | $0 to $2.8M |
I hope this is getting you at least a little bit excited. By investing the “extra” or over-saved portion of our savings in small-cap value, history suggests we could end up with much more to enjoy or pass on to our heirs. Perhaps just as interesting is the fact that the lowest 10th percentile balances, the “bad luck scenarios,” are actually better with the second fund added. Of course, we can’t buy the past, but if the future looks even a little like the past, it will help.
The Two Fund for Life strategy is fairly easy to apply in working and retired years. It helps the earliest in life where target-date funds tend to be overly conservative, and late in life with assets earmarked for the next generation. In both cases, augmenting a target-date fund with a second all-equity fund seems likely to improve long-term returns with only small increases in drawdown risks. Though the approach is simple, it provides world-wide diversification across thousands of companies, with dynamic age-related portfolio risk management, and does it all at a very low cost.
For more details, see https://paulmerriman.com/2-funds-for-life/.
Chris Pedersen is director of research and writer for The Merriman Financial Education Foundation. His mission there is to develop practical solutions to help investors in all walks of life succeed on their way to financial independence.
