Retirement, Target Date Funds, Tax Considerations; Oh My!

Are Target Date Mutual Funds the Holy Grail for Investors? Part 2

Are you saving at a sufficiently high rate that realistically you could have enough target date retirement fund assets to support your lifestyle throughout retirement? Will those assets hold up to inflation during retirement, and would they last even if you and/or your spouse live a very long time?

These are a mouthful of heavy questions.

target date retirement funds

There are two complementary approaches to answering these questions about the adequacy of retirement date fund assets. First, you can read a very helpful study about required lifetime savings rates and asset accumulation along the way. Second, you can use a lifetime financial planning tool to model your current and future assets and cash flows, while testing various asset allocation strategies. (Barbara’s comment; created by the post author for a very reasonable price)

First, read the study about required lifetime savings rates and asset accumulation.

The study to read is a research paper by Ibbotson, et.al. from the 2007 Journal of Financial Planning, which you can download here: “National Savings Rate Guidelines for Individuals.”

This paper discusses required savings rates at different ages and income levels needed to support one’s living standard in retirement. It also provides guidance on how to adjust required savings rates to take into account assets that have already been accumulated. In particular, Table 2 lists saving rates and asset accumulations by age to achieve 80% replacement of pre-retirement net income, depending upon age, income, and any accumulated portfolio.

Investors considering target date funds and other asset allocation strategies can use a lifetime financial modeling tool to understand the implications of various asset allocation models. The do-it-yourself home lifetime time financial planning software tool, VeriPlan, allows an investor to model, project, and compare their lifetime investment portfolio returns using a variety of asset allocation methods, including lifetime fixed and adjusted lifetime percentage methods.

The author of this article developed VeriPlan, an adjustable lifetime asset allocation calculator available on the MyFinancialFreedom.com website. Two of the adjustable lifetime asset allocation calculator methods that are supplied with this inexpensive tool are age related and can easily model both “to” and “through” retirement asset allocation models. After comparing projection scenarios using different asset allocation models and assumptions, you will understand much better the trade-offs associated with different lifetime asset allocation methods. (Barbara’s comment: I haven’t tried this calculator myself, but have high regard for the creator and author of this series, Lawrence Russell).

Do you have other investment assets that should be considered along with your investment in a target date retirement fund?

One retirement and investment planning mistake that many investors make is to make isolated decisions about individual investment holdings without considering all their investments as a unified portfolio. While this is a much longer discussion than time allows for here, you should be aware that all best practices for personal and institutional investment management that have been developed over the past sixty years focus on the entire portfolio as a collective combination of assets that should be optimized.

In other words, look at your entire portfolio as one pie, with separate asset class allocations (pie pieces). Some of these asset allocations may be held in various “accounts” such as your 401(k), your partners investment brokerage account, and a Roth IRA.

Rather than making piecemeal and disconnected decisions about investment components, all asset holding should instead be evaluated concerning how they contribute to the aggregate risk and return profile for the portfolio. In addition, the reduction of portfolio investment costs and the minimization of investment related taxation across a portfolio are very important considerations.

Investment cost reduction and tax minimization both can significantly increase the net investment returns that individual investors will actually keep for themselves to fund their expenses in retirement. (Barbara’s comment, with few exceptions, I prefer low cost index funds)

Tax Considerations Influence Where To House Your Investment Assets

One very important aspect of overall portfolio tax optimization relates to what is known as your “investment asset tax location strategy.” At a high level this means that stock, bond, and cash assets tend to yield returns which are taxed differently under the U.S. federal income tax laws. Most bond and cash returns are taxed at federal ordinary income tax rates. In contrast, when managed properly, capital gains and qualified dividends usually associated with equity asset returns can be taxed at significantly lower long-term capital gains tax rates.

uncle sam taxes library of congress
Uncle Sam Wants You to Pay Taxes

In addition, different kinds of accounts have various taxation characteristics. For example taxable investment accounts are taxed dissimilarly than traditional tax-advantaged retirement accounts, such as IRAs, 401k’s, 403b’s, 457s, etc.

When one optimizes across an investment portfolio, it is preferable to place equity investments in taxable accounts, and bonds and cash in traditional tax-advantaged accounts. To understand why this is the case, read this webpage, which provides a very helpful discussion of “investment asset tax location” strategy and provides a clear example of how is used.

Target Date Funds and Taxes

Now, what is the relationship between target date retirement funds and optimization of your overall portfolio with respect to taxes and “asset tax location?”

Many, if not the majority of investors, invest in target date retirement funds through some kind of tax-advantaged retirement account, which defers current taxes on investment returns and investment appreciation until retirement. If an investor’s total portfolio of investments are in a target date retirement fund, then buying a target date retirement fund within such a retirement account could makes sense. This scenario assumes that the target date fees are low and the asset allocation glide path matches the investor’s lifetime investment risk and return preferences.

What if you didn’t save enough when you were younger?

However, many investor saving for retirement — especially those who did not save enough in their early working years — will find that contribution limits on tax-advantaged retirement accounts will not permit them to save enough to maintain their life style in retirement. These investors realize that they have to save more and those additional savings will end up in taxable accounts.

For these investors with financial assets in both taxable and tax-advantaged accounts, buying a target date retirement fund within their tax-advantaged retirement accounts would be sub-optimal from the perspective of minimizing their tax obligations. Instead, such investors usually benefit more by holding the lowest cost, most broadly diversified bond funds within their tax-advantaged retirement accounts. That shelters the bond dividends from ongoing tax liabilities.

Do you already have any kind of financial and investment plan and do you reevaluate it at least once a year?

If you have a financial plan and reevaluate it periodically, it might also occur to you that you do not need to hold a retirement date mutual fund, just to implement a slowly declining exposure to equities over the years. Since cash, bond, and stock asset class values change at unpredictable rates over the years, at least annual portfolio re-balancing is recommended to maintain the desired risk and returns characteristics of your portfolio. If you want to slowly change and reduce your equities exposure over the years and you are going to re-balance your portfolio anyway, then it is a relatively straightforward task to self-assemble your own “target date fund.” Very often this can be done with lower investment costs and better investment tax optimization.

If you have a full range of investment choices and can purchase the lowest cost index funds from Vanguard, Fidelity, Schwab, etc. you could make your own target date retirement fund and substantially reduce your investment costs. This might be true even if you select a target date retirement mutual fund from Vanguard, which offers the lowest cost target date retirement funds on the market.

While the underlying index mutual funds that make up Vanguard’s target date retirement fund family are already very low cost, you might do better through self-assembly.

Vanguard’s target date funds sometimes invest in underlying Vanguard index mutual funds using the “Investor” share class. However, if you have enough to fund each of the component bond and stock mutual funds with at least $10,000, then through self-assembly you could qualify for the even lower cost “Admiral” share class.

Although the difference in management expense ratios, might seem very small, keep in mind that these share classes hold the same investments. Even small reductions in investment expenses can provide a growing advantage over the decades that you would hold your self-assembled target date retirement fund assets.

Am I making this investment within a retirement plan that offers a limited selection of investment alternatives?

Finally and despite all that has been said above, if retirement plan choices are limited then sometimes choosing within a target date fund family is the best one can do. Unfortunately, many employer sponsored retirement fund management committees are really clueless about investing. They let financial companies talk them into loading up their employee retirement plans with expensive, actively managed investment funds which are much more likely to lead to inferior net returns over the decades that a worker saving for retirement. These company committees do not understand that they should at least providing employees the choice to invest in a variety of the lowest cost and most broadly diversified index mutual funds, which would serve their employees far better over the years.

Sometimes employees will find that a target date investment fund family within their employee sponsored retirement plan is the best alternative within a limited selection. However, such employees should not necessarily choose the target date fund with the year in its name that is closest to the employee’s planned retirement year. Instead the employee might choose another year among the retirement date fund family.

An alternative year target date fund could be chosen to better match the employee’s current investment risk tolerance. Furthermore, since these target date funds change their asset allocations slowly over the years, the employee could occasionally shift some or all of their target date holdings to a different target date year funds. Doing this could allow the employee investor to maintain their desired asset allocation, even though it might vary significantly from the glide path proposed by the target date fund family. Despite the added layer of fund-of-fund expenses, this approach can make the best of a not so great situation, if the target date funds have relatively low costs.

Of course, there is one more thing that you could do, and that is complain to those within your company about the lousy choices available within the employer sponsored retirement plan. If you do not feel that you can articulate why employees should have the choice of lowest cost index mutual funds, you could suggest that they read the Buyers Guide to the Lowest Cost Mutual Funds book, which clearly lays out why cheaper funds are better funds for retirement investing.

Guest author; Lawrence J. Russell is the author of both this low cost mutual funds book and the article that you have just read. He is President and Managing Director of Lawrence Russell and Company, a personal financial planning services provider and registered investment adviser in Pasadena, California. Larry is also the designer and developer of VeriPlan, a lifetime financial planning software product for home use. He holds degrees from M.I.T. (BS ’75), Brandeis University (MA ’79), and Stanford University (MBA ’82). Find all of his books and software at his website.

For more target date retirement fund information, read Part 1 of this series; Should I Invest In a Target Date Retirement Fund?

What are your thoughts about investing in target date retirement funds?

image credits; 1.) google images_wikipedia(original kitten); 2.) Uncle Sam-library of congress

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