Create a target-date retirement fund? Really?

Why in the devil would anybody want to reinvent the wheel, so to speak, when most big mutual-fund companies already have well-run funds available at reasonable cost?

It’s a good question, and I can think of several answers that might make this an attractive idea. They all boil down to the same idea: You might make more money if you do it yourself.

(In addition, some people just like to tinker and build things themselves. How else to explain the widespread popularity of kits that allow you to pay more and invest lots of time in making everything from potholders to dinners to radios to sailboats?)

In the case of a target-date fund, I think you can actually save money — or make a whole lot more of it — if you’re willing to invest the time.

Vanguard’s target-date retirement funds levy annual expenses of roughly 0.13% to 0.15%.

In an article I wrote last year, I showed that a regular modest investment plan (starting at $1,000 a year in 1970 and increasing by 3% each year thereafter) in the S&P 500 index could grow to $1.88 million over 48 years, assuming a 0.1% annual expense ratio for an index fund.

Without the 0.1% expense, the final total would have been $1.95 million. The difference — about $70,000 — would buy a lot of fancy dinners in retirement. And if you invested $5,000 a year instead of $1,000, the difference would let you buy a boat (assuming your spouse went along with that idea).

Can you shave 0.1% off the cost of a target-date fund? I think you can.

For example, you can get an S&P 500 index fund for about 0.04% instead of paying 0.15%.

There’s another way — not obvious until you look under the hood of target-date retirement funds — that I believe you could add another 10 basis points (0.1%) to your returns.

A commercial mutual fund takes money in and pays money out every business day. This lets the fund essentially rebalance its portfolio every day.

My calculations suggest you can get an additional 0.1% of return if you rebalance annually instead of monthly. (The difference is probably even greater when compared with daily rebalancing.)

Their glide path

I think it’s also very likely that you’ll make more money if you adopt your own glide path toward retirement.

Every target-date fund has a glide path that gradually moves investments out of equities and into bonds as retirement approaches. This is a great service to shareholders.

However, even the target-date funds with the farthest-out retirement assumptions hold around 10% of their portfolio in bonds. This excessive caution is neither necessary nor helpful for young shareholders, whose greatest need is for long-term growth.

Bonds protect investors from bear markets that might prompt them to bail out. But for investors starting with relatively small balances, regular contributions dramatically reduce downside volatility all by themselves.

Over the long haul, equities produce significantly higher returns than bonds.

From 1929 through 2018, the average compound 40-year return of long-term U.S. government bonds was 5.4%. The average compound 40-year return of the S&P 500 was 10.9%.

Even if that difference applies to only 10% of a portfolio, it can matter greatly when compounded over decades.

Your glide path

I suggest you adopt an all-equity portfolio until you’re 40 years old — roughly 25 years from retirement.

This allocation should give you about a 0.2% higher compound return compared with Vanguard’s glide path, which holds roughly 10.4% in bonds between ages 35 and 40.

When you reach retirement, I suggest you consider holding 50% to 60% in equities permanently — more than Vanguard’s glide path allows.

This could make a meaningful difference in what you can spend in retirement or leave to your heirs.

Better diversification

The majority of equity assets in most target-date funds are invested in U.S. and international total stock market funds, which are dominated by large-cap blend stocks.

You can do better.

Small-cap value stocks have handily outperformed the S&P 500 over the long haul, yet they make up only about 2% of the typical target-date fund’s equity holdings.

My suggestion: Split your equity allocation equally among small-cap value, a U.S. total market index fund, and an international total market index fund.

If you prefer to skip international stocks, split equities 50/50 between U.S. total market and small-cap value.

Can you actually do this?

If you have access to a 401(k) or similar plan, you probably can.

Most plans offer an S&P 500 fund or a total market fund, and many offer at least one U.S. value fund. Even large-cap value funds can significantly boost long-term returns.

If your plan doesn’t include small-cap value, you can open a Roth IRA and hold that asset class there.

You can also use a simple two-fund alternative if you prefer.

No matter how you do it, creating your own target-date portfolio gives you more control over risk, diversification and long-term return.

You can learn more at my website, where you’ll find articles, a podcast and a 50-minute video on this topic.

Richard Buck contributed to this article.