The Vanguard Target Retirement Funds are one of the largest “set-and-forget” mutual funds that own a mix of stocks and bonds that automatically adjust over time based on your targeted retirement year, with combined assets across the institutional and retail classes of over $600 billion.

Reader rp pointed out that on December 30th, 2021, many Vanguard Target Retirement funds had their price (NAV) drop by over 10% in a single day! This was mostly the result of an abnormally large year-end long-term and short-term capital gains distribution. Taken from Vanguard’s final year-end estimates PDF:

Here is an example for the Vanguard Target Retirement 2040 Fund (VFORX). The 2021 cap-gains distribution was roughly 40 times as large as for 2020. Yet, other funds with a similar asset allocation like the Vanguard LifeStrategy Funds did not have a similar result. What happened?

Background. A mutual fund is forced to make a capital gains distribution when it sells stocks (or bonds) that have appreciated in value, thus realizing capital gains. There are various reasons why a mutual fund might sell stocks:

• An actively-managed fund might sell shares of stocks that they believe are over-valued in order to purchase shares of another business.
• An index fund might have to sell shares if the underlying index changes. By definition, an index fund must track an index. For example, sometimes the S&P 500 will remove a company from its index.
• A balanced mutual fund might rebalance between stocks and bonds. If the target is 80% stocks and 20% bonds, the fund might sell some stocks after a big bull run in order to buy some bonds and revert back towards the target.
• A mutual fund has a high number of redemptions (cash outflows), such that the fund has to sell assets in order to come up with the cash to satisfy all those withdrawals.

Vanguard Target Retirement Funds don’t follow an index themselves, as they are a “fund of funds”. That means they are basically a wrapper for the component index funds. For example, the Vanguard Target Retirement 2055 Fund (VFFVX) is composed of:

• Vanguard Total Stock Market Index Fund Investor Shares 54.90%
• Vanguard Total International Stock Index Fund Investor Shares 35.50%
• Vanguard Total Bond Market II Index Fund Investor Shares 6.60%
• Vanguard Total International Bond Index Fund Investor Shares 2.80%
• Vanguard Total International Bond II Index Fund 0.20%

However, these underlying funds did not have huge capital gains distributions themselves that might flow through. In fact, the main components had zero capital gains to distribute, while the other distributed tiny amounts less than 1%.

What we have left is that the Target Retirement Fund itself sold some shares of the component index funds. Stocks did go up in 2021, but not nearly enough to warrant such a huge capital gain. Besides, stocks also went up a similar amount in 2020, and as we saw above the 2020 capital gains distribution was 40x smaller.

In addition, the Institutional Target Retirement 2040 fund only had cap gains distributions of 0.39% of NAV. This fund should have the same rebalancing needs as the retail version for individual investors. The rest of the Institutional Target Retirement years had similarly low distributions.

Strange! Thankfully, I found a great clue by “cas” in this Bogleheads thread. From reading the annual reports for VFORX, we find that as of 3/31/21, the net assets for Target Retirement 2040 was about $35 billion. From January through September 2021, over $16 billion of shares were redeemed from the Target Retirement 2040 fund, while only $6 billion were purchased. The underlying investments grew in value, but investors took out a net $10 billion in cash over the first 9 months of 2021! The large capital gains distribution was primarily due to these large net redemptions.

Okay, but again, why? The main problem was that the “Institutional Target Retirement Funds” are not a share class of the “Target Retirement Funds”. In December 2020, Vanguard lowered the plan-level minimum investment requirement for the Institutional Target Retirement Funds to $5 million from $100 million. Now, as long as an employer’s 401k plan had $5 million in assets across the entire plan (not just one person), they could now access the much cheaper Institutional version… a big savings for possibly thousands of small businesses.

Let’s check the annual reports again. Over the same time period that Target Retirement 2040 lost $10 billion in net cash outflows, the Institutional Target Retirement 2040 Fund gained $13 billion in net cash inflows. Coincidence?

Vanguard incentivized small business retirement plans to sell their holdings from Target Retirement in order to buy Institutional Target Retirement funds by offering them a 30% to 50% reduction in fees, and they did so, moving over billions and billions.

Eventually, in September 2021, Vanguard announced that they would merge each of the Vanguard Institutional Target Retirement Funds into its corresponding Target Retirement Fund. The mergers are not scheduled to be completed until February 2022. There may be more outflows until then. A merger would not have created any forced selling, so why not do this in the first place?

I wonder if Vanguard made a mistake and they simply didn’t realize this would create large outflows. Or perhaps they just didn’t care? Either way, it’s another recent blemish on their record. The order and time delay in which they did things indirectly hurt the individual taxable investors of Target Retirement funds. They should have simply merged the two series in the first place.

This is why the DIY investor should strongly consider only investing in the “raw materials” and “cook from scratch”. VTI, VXUS, and BND ETFs can be held at any brokerage firm, bought and sold for free, distributed tax-efficiently between 401k/IRA and taxable, and are available for ETF-pair tax-loss harvesting in a taxable account. On the other hand, this is something of a one-time event, so you may value the simplicity of Target Retirement funds above the potential drawbacks.

If you like the idea of “auto-pilot” but also want to be be only one allowed to program the autopilot, check out out M1 Finance and their pies (which you can always break back up into component ETFs) as well as Utah My529 and their “customized glide path” option for college savings. I don’t like the fact that Vanguard can always change up their target asset allocation to whatever is trendy. (I have the same issues with the robo-advisors like Wealthfront and Betterment.)

Summary. Vanguard Target Retirement Funds (Investor shares) made large capital gains distributions at the end of 2021. This was mostly due to large outflows from Target Retirement Funds (owned by individual investors and small businesses) into their separate Institutional Target Retirement Funds, as Vanguard lowered the minimums for the Institutional funds from $100 million to $5 million in December 2020. This appears to have forced the Target Retirement funds so sell their investments and incur large capital gains.

If you hold Target Retirement funds in a tax-deferred accounts like 401k/403b/IRA, this has no taxable effect on you. The net asset value (NAV) dropped by a certain amount, and you received a distribution for the same amount. You most likely have it set to reinvest immediately anyway. However, if you held this in a taxable account, you received a taxable distribution. You now owe some extra tax and lost the ability to compound that money into the future. It’s not a disaster, but it did hurt your returns a little, in my view unnecessarily as Vanguard could have handled things differently on their end.

Financial freedom seekers usually have a Number – the value at which their investments can support their spending indefinitely. This is directly linked to “safe withdrawal rates”. For example a 4% safe withdrawal rate is a 25x multiplier – meaning $30,000 in spending needs not covered by Social Security, annuities, or pensions would require 25 x $30,000 = $750,000. Morningstar recently released a 59-page research paper called The State of Retirement Income: Safe Withdrawal Rates (summary article) that digs deeper into the “4% rule”. The headline is that they now estimate 3.3% a conservative base rate (30x multiplier):

What’s a safe withdrawal rate for retirees? We estimate 3.3%. However, there are various factors that could affect this percentage, resulting in the retiree withdrawing a significantly higher amount. This report explores ways that retirees can make their savings last longer without compromising their standard of living.

Instead of focusing on the 3.3% base rate, look at the various ways you can improve it. The 3.3% base rate assumes a 50% stock/50% bond portfolio, fixed withdrawals (adjusted upwards for inflation annually, no matter what) over a 30-year time horizon, and a 90% probability of success. What if you changed up some of these assumptions?

Lever #1: Hold a higher percentage of stocks. Historically, having a minimum amount of stocks is important in order to outpace inflation. However, going past 50% to 75% stocks no longer helps your minimum safe withdrawal rate. Not much room for improvement here.

Lever #2: Tolerate lower safety (success rate). This chart is useful to help accept the role of luck for a stock-based retirement portfolio. The fact is that 50% of the time, you could have withdrawn 4.7% and been just fine. You simply don’t know. (This is hard for me as a planner.) The retiree “Class of 2011” could have spent more than that so far without even denting their nest egg. However, the “Class of 2021” may have a very different experience. Going down to 80% probability of success moves you up from 3.3% to 3.9%.

Lever #3: Don’t keep adjusting upward for inflation. Your personal inflation rate might not keep up with the national averages. You might very well spend less as you age. If you adjust for 3/4th of inflation, that 3.3% goes up to 3.6%.

Forgoing inflation adjustments–at least in part–is another lever. That might seem farfetched in the current environment, given that inflation is top of mind. But research from David Blanchett, formerly of Morningstar but now at PGIM, has demonstrated that retirement spending doesn’t necessarily track inflation and often trends down throughout the lifecycle. Our research shows that the retiree who adjusts his or her paycheck by just 75% of the actual inflation rate would be able to take a starting withdrawal of 3.6%, for example.

Lever #4: Work longer. Make more money, make retirement period shorter. Not much fun, but effective. My view is that any amount of income will help reduce your withdrawal rate, if you have the time and ability. It is less common nowadays to go from full-time job to zero income. Working 10 hours a week feels much different than 40-50 hours a week.

Reducing the time horizon for drawdown–for example, by delaying retirement a few years–can likewise contribute to a higher starting safe withdrawal rate. For example, delaying retirement by five years and truncating the in-retirement spending horizon to 25 years from 30 results in a starting safe withdrawal amount of 4.1%.

Lever #5: Flexible spending based on market performance. There are several ways that you could adjust your spending in retirement in response to your portfolio’s return. In general, you’d want to spend less when the market is down. Some of this will come naturally as it’s easier to cut back on spending when you see your friends and neighbors cutting back as well. However, I was surprised to see that several of the proposed methods really don’t change the numbers much.

The method that does help significantly is called the Guyton-Klinger “guardrails” method, which allows inflation adjustments but applies “guardrails” so that the spending rate stays within 20% of the initial withdrawal percentage. Lets say your initial percentage is 4%. If markets go sky-high, the guardrails let you spend at least 3.2% of your new portfolio value (with inflation adjustments). If markets plummet, the guardrails let you spend at most 4.8% of your new portfolio value (with inflation adjustments).

Hold up! Early Retirement Now has an excellent post about how the Guyton-Klinger guardrails are much more “variable” than just +/- 20%. The guardrails move with the portfolio value. If you started out taking $40,000 out of a $100,000 portfolio, by following this rule starting in 1966, your income would have dropped to below $20,000 a year! A 50% drop in income is far too flexible for most people.

My personal thoughts. Every year that passes, I pay less attention to historical backtests and precise safe withdrawal rates. Instead, I care more about understanding the earning power of the assets that I own (including my own skills), and understanding the structure and flexibility of my expenses.

In regards to market returns, it is better to be lucky than anything else. Let’s say you retired about a year ago on October 31st, 2020 and owned the Vanguard Balanced Index Fund (VBIAX) that is 60% US stocks and 40% US bonds. If you had a $1,000,000, a 4% withdrawal rate is $40,000. But a year later, on October 31st, 2021, your portfolio would be just shy of $1,200,000 ($1,195,584) even after taking out $40,000 during the first year. This is just after one year!

In other words, 3.3% could easily be obsolete in a year. You are multiplying a safe withdrawal rate by something that can easily move up or down 20% each year, so why care about decimal points? Focus on what you can control. Looking back at all the levers above, here is what I can control:

• Accept that a stock-based retirement portfolio will rely on luck. 3% = very safe. 4% = probably safe. 5% = risky. 6% = not safe.
• Keep your portfolio in retirement somewhere between 50% and 75% stocks, with the rest in investment-grade bonds.
• Don’t blindly keep taking out more money each year for inflation.
• Working longer may be required, but explore ways to downshift while still making some income. Even small amounts of income make a difference. For example, 1% of $750,000 is $7,500 per year ($144/week). Earning $144 per week in income would move you from a 5% withdrawal rate to a 4% withdrawal rate, from a 4% withdrawal rate to a 3% withdrawal rate, and so on.
• Don’t plan to spend the same amount every year. Spend less when markets are down, as most people do anyway. Think about the flex in your budget. Don’t lock in long-term commitments (vacation home ownership, any debt, agreements to pay for your kid’s X). Pick things that you can shut off (vacation rentals, travel, dining out).

Some investors like to break down their portfolio into several different asset and sub-asset classes. One long-standing example of the “slice-and-dice” is the “Ultimate Buy-and-Hold Portfolio” recommended by Paul Merriman (see pie chart; expanded labels below). You don’t need to hold every one of these asset classes, but when held in combination they historically offer a higher return with lower volatility.

• S&P 500 (US Large Cap Blend)
• US Large Value
• US Small
• US Small Value
• US REIT
• International Large Cap Blend
• International US Large Value
• International Small
• International Small Value
• Emerging Markets
• Short-term/Intermediate-term Bonds

For a long time, Dimensional Fund Advisors (DFA) offered some of the best lower-cost mutual funds tracking these types of sub-asset classes, but they also required you to invest through a DFA-affiliated financial advisor (and pay the accompanying management fees). Eventually, some former DFA executives and employees broke off and started Avantis ETFs, which are available to any investor with a brokerage accounts and offered a good DFA alternative. Avantis’ assets under management have been growing…

Lo and behold, DFA has just announced a big expansion of their DFA ETF lineup. Competition works!

Newly-listed DFA Bond ETFs

• Dimensional Core Fixed Income ETF (DFCF)
• Dimensional Short-Duration Fixed Income ETF (DFSD)
• Dimensional National Municipal Bond ETF (DFNM)
• Dimensional Inflation-Protected Securities ETF (DFIP)

Future DFA Equity ETFs

• International Core Equity 2 ETF
• Emerging Markets Core Equity 2 ETF
• US Small Cap Value ETF
• International Small Cap ETF
• International Small Cap Value ETF
• Emerging Markets Value ETF
• US High Profitability ETF
• International High Profitability ETF
• Emerging Markets High Profitability ETF
• US Real Estate ETF

Existing DFA ETFs

• Dimensional US Core Equity Market ETF (DFAU)
• Dimensional International Core Equity Market ETF (DFAI)
• Dimensional Emerging Core Equity Market ETF (DFAE)
• Dimensional US Core Equity 2 ETF (DFAC)
• Dimensional US Equity ETF (DFUS)
• Dimensional US Small Cap ETF (DFAS)
• Dimensional US Targeted Value ETF (DFAT)
• Dimensional International Value ETF (DFIV)
• Dimensional World ex US Core Equity 2 ETF (DFAX)

Some of the confusing names are a result of these ETFs being conversions from the old mutual fund versions. Even though I try to keep things relatively simple and humble, I welcome these new investment options to the competitive marketplace along with their reasonably-low expense ratios. I may even switch my TIPS holdings to the DFA TIPS ETF (DFIP), as it is cheaper than the iShares TIPS Bond ETF (TIP).

I use Vanguard for my “core” index funds, but about 10% of my total portfolio is split between US Small Value and International/Emerging Small Value stocks. I recently bought/rebalanced into some of the new Avantis International Small Cap Value ETF (AVDV), but will keep an eye on the new DFA version. I suppose they could be a tax-loss harvesting ETF pair, but I have them inside a tax-sheltered account.

I always keep track of the Vanguard Target Retirement 20XX Funds (TRFs) because:

• They are a low-cost, broadly-diversified, “all-in-one” fund that I believe are a good starting point for both beginning investors and all investors that desire simple effectiveness along with professional management.
• I have recommended them to my own immediate family, and some of them hold Vanguard TRFs as a significant chunk of their retirement portfolios. I feel a responsibility to make sure they remain solid investments.
• I view them as an indicator of what Vanguard executives think is the optimal asset allocation mix for most people.

For a while now, one of the primary “cons” of Target Retirement Funds was that it would be much cheaper to buy the individual component ETFs yourself. You could build your own simple portfolio with only three ETFs – VTI (US stocks), VXUS (Global non-US stocks), and BND (US Bonds) at any brokerage firm. Your combined annual expense ratio would be about 0.05% (5 basis points). Yet, the Target Retirement Funds line-up currently charges between 0.12% and 0.15%. You could sign-up for the Vanguard Digital Advisor Services and and only pay 0.20% “all-in” (0.15% for the advice plus 0.05% from ETFs).

Vanguard recently announced they were “streamlining” the Target Retirement Fund line-up and lowering the expense ratio to 0.08% (8 basis points) for each TRF, with an estimated completion date of February 2022. That would be a 47% fee reduction for the stock-heavy TRFs, and a 33% cost reduction for the bond-heavy TRFs. Vanguard estimates $190 million in aggregate savings in 2022 alone as a result of this cost reduction.

As a result, Target Retirement Funds are again safely amongst the cheapest “advised” option for individual investors. By this, I mean that an individual investor decides how much money to put in and an algorithm makes the investment decisions. You don’t have to worry about picking the asset allocation, adjusting as you age, remembering to buy/sell different ETFs every month, enter limit orders, rebalance, and so on. You just send them $100, $500, whatever and it gets put to work. This is essentially the same idea as robo-advisors like Wealthfront, Betterment, and other “guided investing” services. Fidelity and Schwab now also have very low-cost index-based target-date funds.

(If you hold Vanguard TRFs in your 401k or other employer-sponsored tax-deferred account, you may own the institutional shares with an even lower expense ratio.)

There will also be a new fund option, called the Vanguard Target Retirement Income and Growth Fund/Trust. This is a fund designed for those in retirement but would like a higher (50%) stock allocation due to various reasons (greater desire for growth, less need for income). This new option would work well for wealthier investors that don’t need/expect to spend it all down and can thus take on more risk. The default Vanguard Target Retirement Income Fund/Trust will remain with its 30% stock allocation.

Here is the current glide path for Vanguard TRFs. For younger investors, TRFs hold 90% stocks and 10% bonds.

For reference, here is a brief history of the major tweaks to Vanguard Target Retirement fund portfolios:

• 2003: Target Retirement 20XX Funds are first introduced.
• 2006: Overall total stock exposure is increased slightly for various Target dates. Emerging markets stocks are added to certain Target dates with longer time horizons.
• 2010: International stocks as percentage of total stock allocation is increased from 20% to 30%. Three of the underlying funds (European Stock Index, Pacific Stock Index, and Emerging Markets Stock Index) were replaced by a single fund, Vanguard Total International Stock Index Fund.
• 2013: International bonds are added as 20% of the total bond allocation. Vanguard Short-Term Inflation-Protected Securities Index Fund replaced the Vanguard Inflation-Protected Securities Fund for certain Target dates with shorter time horizons.
• 2015: International stocks as percentage of total stock allocation increased from 30% to 40%. International bonds as percentage of total bond allocation increased from 20% to 30%.

Here’s a follow-up to my post about the return gap of retail investors due to poor timing. For every seller of a stock share, there is a buyer. Therefore, if the timing of retail investors is reliably a little worse than average, we also know that someone else is on the other side of all those trades. Is there a group of non-retail investors that is reliably making money off the “dumb money” trades of retail investors?

Larry Swedroe digs into this question in his Advisor Perspectives article The Suckers at the Investment Table:

New research confirms that institutional investors, such as mutual funds, outperform the market before fees, and they do so at the expense of retail investors. That is bad news for retail investors and for investors in active mutual funds, who underperform after fees.

The research finds that the stocks and bonds individual investors buy go on to underperform and the ones they sell go on to outperform – demonstrating that retail investors are “dumb money.”

Unfortunately for fund investors, the same large body of evidence demonstrates that while mutual funds generate gross alpha, their total expenses exceed gross alpha, resulting in negative alphas for their investors.

If on average, an actively-managed mutual fund generates 0.7% of gross alpha, but after you subtract the expense ratio and trading costs which add up to nearly 1%, the net alpha is still negative. The active manager is the winner, taking all of the alpha for themselves in the form of relentless fees taken as a percentage of the entire asset base. The retail investor/customer still loses out. An fairer fee structure would be to take a larger percentage, but of the alpha only.

People will continue to argue about this, but I’m not surprised to see that these studies found alpha. It’s just much, much harder to do than most people think, and that’s exactly why you almost never see a fee structure based on alpha (thought they do exist). Even Charlie Munger, who is famous for his stock-picking skills and disagreement against the “hard” form of Efficient Market Theory, only says that the top 3% to 4% of professional investment managers will outperform (source):

I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

In the end, costs always matter. If you find a genius to pick stocks but they cost more than they help, then you still lose. The only actively-managed mutual funds that I have seriously considered buying are from Vanguard, which improves the odds with substantially lower expense ratios and a history of investor-friendly practices. As a DIY individual investor buying index funds, you can keep your head down and “grind out” reliably above-average returns over time due to the rock-bottom costs. (There, I fit in my own poker reference!) Even as a DIY individual stock investor, as at least I understand what I own and don’t have to pay a 1% management fee every year.

Periodically, Vanguard publishes asset class return forecasts for the next 10 years. Here is their most recent one for September 2021. To their credit, they have also published a recent follow-up post tracking both those forecasts alongside the actual returns in retrospect. This is a good lesson on the difficulty of any sort of short-term market prediction, even after allowing yourself 10 years and wide error bars.

Below is a chart tracking their forecasts for the future 10-year average annualized returns of US stocks. Eyeballing their chart, for 2010-2020 their range of confidence was somewhere between roughly 5% and 10% annually, for a median around 7.5%. This accounts for their model’s 25th percentile to 75th percentage range of possible outcomes. This is a pretty big range! $100,000 times 5% annualized returns after 10 years is $163,000. $100,000 times 10% annualized returns after 10 years is $259,000.

Even accounting for that wide range, their forecast for US stocks was off. While the curve looks vaguely similar, US stocks did significantly better than their forecast:

Again, even accounting for the huge range of guesses, their forecast for international stocks was also off. Global non-US stocks did significantly worse than their forecast:

Vanguard’s original chart focuses on their 60/40 portfolio, which happens to look a lot better. Why? Their 60/40 portfolio consists of 36% US equities, 24% global ex-US equities, 28% US bonds, and 12% ex-US bonds. For one, future bond returns are much more simple to predict than stock returns. Your current 10-year yield is going to be pretty close to your eventual 10-year return. In addition, their US equities forecast was really wrong in one direction (too low), while their international equity forecast was wrong in the other direction (too high), so they tended to offset each other. Is this diversification in action? Certainly, yes, but also luck in my opinion. Both could have also been wrong in the same direction.

Should we just ignore this stuff completely then? I keep thinking back to this illuminating chart comparing the contributions of earnings growth, dividends, and P/E ratio changes to the total return of the S&P 500. Earnings growth and dividends have been pretty consistent for over 70 years, but the overall swings in return have been mostly caused by P/E ratio expansion and contraction.

Consider the analogy that P/E ratio expansion and contraction behaves like a rubber band. It can stretch pretty far, much farther than you might expect, but as you keep stretching it, the stronger it will eventually want to come back. But you never really know how far it can stretch, or when it will snap back. Forecasts can be wrong for a long, long time. You have to balance knowing that the run will end eventually, but not knowing when. Someone will always be right in retrospect.

If only we could focus solely on the earnings growth and dividends. Those are what really matter in the long run. This is the behavioral benefit of remembering that dividends are a share of profits being distributed to you as a business owner. Even if prices on a screen are dropping, the businesses are still working hard, making profits, reinvesting some for more earnings growth, and sending some of it to you as cash.