Millennials: There's a Problem with Your Target-Date Retirement Fund

And it's got nothing to do with entitlement.

If you have an employer-sponsored retirement plan such as a 401(k), you've no doubt heard the recommendation to contribute to a target-date retirement fund. It's not horrible advice - a target-date fund is the ultimate "set it and forget it" investment option.

The premise of a target-date fund is that you select the fund with the year you expect to retire. For example, "Target Retirement 2065 Fund". The fund managers will automatically adjust the allocation of your portfolio based on the year you selected. The portfolio will start off with an aggressive stocks-based allocation and slowly transfer into more conservative assets such as bonds as your retirement year approaches.

This means that with a target-date fund, you don't ever need to worry about allocating your portfolio to the right mix of aggressive and conservative assets. The fund simply takes care of itself. The best part is that most target-date funds have relatively low fees in the form of operating expenses.

Okay... that all sounds great. So what's the problem?

There's a specific asset class that has consistently outperformed every other asset class over a 20+ year period.

If you had invested $10,000 in a broad US stock market index in the year 1972, you'd have roughly $1 million today. Not bad, right? Well, here's the kicker: if you had invested in this mystery asset class instead, you would have $2 million. That's twice as much total gain in the time period from 1972 until 2018, and that includes reinvested dividends.

This mystery asset class is called mid-cap stocks.

These are the publically traded mid-size companies that usually don't pop up in the news feeds as often as the big guys. Examples of mid-cap stocks include Western Digital, Dollar Tree, and Best Buy. The beauty of owning shares in mid-cap companies is that the implication of their current size is that they still have plenty of room to grow. This growth comes at the expense of being a bit more volatile when compared to large-cap stocks, so mid-cap stocks tend to do worse in an economic downturn. This can make some folks uneasy.

Back to the Millennials

Amidst all the noise about how we should or shouldn't label millennials, they really do have one thing in common: they are all young adults in their early 20's to mid 30's. This means most millennials have anywhere from twenty to sixty years until retirement. That's more than enough time to invest in a more aggressive mid-cap stock-based portfolio than even the most aggressive target-date fund, such as the Vanguard Target Retirement 2065 Fund.

Anyone with 20+ years until retirement can afford to take more risk than a typical target-date fund allows.

Let's test this theory with a simple backtest method. We'll compare how two different portfolios would have performed if we had invested them over a defined period in the past. Our initial investment will be $5,000, and we'll contribute $500 per month like someone might do in a 401(k). We'll choose the twenty year period from 1998 until today 2018. Note that this time period includes two major US recessions where mid-cap stocks should absorb modest to severe losses. Will they recover in time?

Portfolio 1

Portfolio 1 will have an allocation matching the most aggressive target-date funds that exist today. A 2065 fund implies a nearly 50-year investment horizon and is made up of the following:

Portfolio 2

The challenger portfolio 2 will look exactly like portfolio 1 except that I will replace the total US stock market index with a mid-cap US stock market index instead. This isn't a perfect allocation, but does the job for this demonstration and is simple.

The Result

Portfolio 2 ends up at a value of nearly $56k, versus the $48k value of Portfolio 1. That's a 16% difference in final performance. You can see in the plot above that the mid-cap heavy portfolio 2 took quite the beating during the 2009 period of the Great Recession, but stormed back strongly in the decade since. More details comparing the two portfolios during this time period are below.

You might argue from the results above that portfolio 2 is riskier than portfolio 1, and the return is not worth the risk. But if a more aggressive portfolio can demonstrate resilience through the greatest economic downturn since the great depression with a 20-year investment horizon, shouldn't young folks be turning up the heat a bit on their retirement investments? Target-date funds don't allow for the level of risk exposure required in exchange for higher long-term returns.

My Proposed Two-Step Solution

1. For folks with 20+ working years left, allocate your retirement investments more closely based on portfolio 2 above. You will want to go in at least once or twice per year to rebalance, but I believe the few additional minutes of work is worth the long-term boost in returns. Just make sure the funds you are selecting in your 401(k) to achieve this more mid-cap heavy allocation have relatively low fees. Any expense ratio of 0.5% or greater is too high. Ideally, you should aim for funds with less than 0.2%.

2. When you do hit that point of having 20 working years left, shift your allocation back over to a target-date fund. The target-date fund won't be too conservative at this point and will deftly land you into retirement with continuous worry-free automatic re-allocations year after year.

Agree? Disagree? Have a question? Feel free to comment down below!