Target date funds are all the rage nowadays, especially inside company-sponsored 401k (k) programs. However, I don’t trust them and don’t like them for a few reasons.
Let’s review our retirement goals before I get into the target date funds. We want to preserve capital, facilitate growth, and generate income during retirement. That’s why many people gravitate toward the 60/40 retirement plan for their nest eggs.
The 60/40 (60% index funds and 40% bonds) plan aims to sell shares of your index funds while bonds generate income. Together, you should be able to live on 4% of your portfolio annually.
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Along came target date funds. Target date funds are mutual or exchange-traded funds that combine the 60/40 strategy in one package.
When I was in the military, I bought the “2040” target date fund inside my Thrift Saving Plan, the military’s 401 (k). As the target year approaches, the fund converts index funds into bonds.
Let’s examine how this conversion happens. The year is 2010, and my 2040 target date fund is 80% index funds and 20% bonds. By 2040, the ratio is 40% stocks and 60% bonds. Eventually, the fund is almost 100% bonds.
Therefore, inside of the fund, you are losing all of your growth in favor of a flight to safety. This is fine if you have your growth outside of this fund.
Tired of Being Broke, Behind, and Bullied?
Why I don’t like target date funds. The first reason I don’t like target date funds is that they are just a collection of other funds.
When I was digging around my 2040 TSP target date fund’s prospectus, I noticed it was just other TSP funds. For example, the growth element was just the common stock and international funds. So basically, it was the S&P 500 (SPY) and an international fund. That’s not the problem.
My main complaint was that the bond element was just a collection of bond funds—not treasuries. That’s right; all of the parts of the target date fund traded on the stock market.
That was my first clue to get out of these funds. I love bond funds, but I don’t consider them bonds. You don’t want your bonds to trade on the stock market; that defeats the purpose of having bonds.
The bond element should have been individual treasury, municipal, and corporate bonds and some money market funds.
The Options Trading Debit Card
We all know that during a downturn, even bond funds take a hit. Therefore, target date funds (stocks and bonds) are going to take a double hit during a market crash—not good.
Target date funds also carry fees, which doesn’t bother me too much. In this world, you have to pay to play. If you don’t want to manage your finances, you’ll have to pay someone to do it for you.
What’s happening inside? The transparency was the main reason I took all of my money out of TSP. TSP funds invest in securities that pay dividends; however, the TSP doesn’t show dividend payments. I never liked that.
Inside a target-date fund, the fund manager will be sitting on massive capital gains from index funds. Their job is to sell the index funds and convert them to bonds along the way.
Again, I don’t trust this. It’s a lot of money for people to handle without mismanagement. I don’t want to trust these people to handle my retirement safety and income.
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Building your own target date fund. But we can do better all by ourselves. We can use index funds and treasury bonds to secure our retirement success.
The most important part of leading a successful retirement is knowing how much monthly income you will need. Again, pick a number, any number.
Assuming you have a paid-off house and cars, $5,000 per month is a good number. Your number may be higher based on property taxes and home insurance.
I am not a fan of selling shares, so let’s try to avoid that process. We can leverage dividends from index funds and bond interest payments.
If we wanted to retire on bond payments alone, we would need $1.5 million at 4%. Index funds only pay around 1.5%, so they aren’t much help.
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The magic of being in control. But we control our lives, not the stock or bond markets. We can use all the tools at our disposal to get the results we want.
Let’s say at age 60, we have $300,000 in index funds and $300,000 in treasuries. We have six more years to invest $2,000 monthly until we draw social security.
We can use our risk analysis to see that we are doing well in the safety and growth elements. We can add a leveraged bond fund (closed-end fund) to get us to the promised land.
Adding Pimco Dynamic Fund (PDI) to the mix allows us to use the 12% dividend yield to spike our income before retirement.
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We can use the last five years to invest $120,000 into PDI. Now, let’s review our income levels as we reach social security.
- $300,000 in index funds equals $375/month
- $300,000 in Treasuries equals $1,000/month
- $120,000 in Pimco Dynamic Fund equals $1,200/month
- Social security equals $2,000/month
Going into retirement at age 66, we would earn $4,575 per month. We can add a roommate paying us $1,000 to round out our monthly income.
Keep it going. The best part of our DIY target date fund is that we can keep increasing our income without selling shares to fund our lifestyle. We can start by reinvesting our index fund dividends, creating more compound growth.
Covered Calls vs. Cash-Secured Puts
I don’t like selling shares, but we can skim some index fund capital gains and invest more into PDI. Let’s say at age 70, we can convert $100,000 from QQQ or SPY index funds and add more into PDI.
That takes us from a 1.5% dividend yield to a 12% one. At $100,000, that is a difference between $125/month and $1,000/month.
The best part of our program is that we can see exactly what we have and where we have it. We can pull the levers to generate and protect as we see fit.
I can’t imagine having $600,000 in my 2040 target date fund earning 2% because it is all on government bonds. Instead, I can put $50,000 in index funds, $50,000 in treasuries, and $500,000 in PDI. I adjust the total to my risk tolerance.
Building Generational Wealth Via Dividends
Conclusion. The mutual fund industry wants you to be scared of your future. They want you to trust them. However, you can open a TreasuryDirect account today and start with all types of treasuries.
You can open an M1 Finance account today and start investing in QQQ, SPY, DIA, and VTI index funds. You can also purchase closed-end funds like PDI, PTY, and PDO.
There is nothing to fear, even if you start small, say $1,000, to build trust in the system. In fact, I fear having all of my trust in a mutual fund manager.
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When you build your own portfolio, you can be more dynamic. If fear is on the horizon, you can add more cash to your bonds. If times look good, add more to the index fund portfolio.
If you need more income, get a roommate and add more to your closed-end funds. You are in total control of your stocks and bond allocations.
Most importantly, you don’t need to sell shares to generate your income for expenses. You can sell shares to convert into more passive income but not to eat or pay bills.
I am under-impressed by the target date funds; we can do better. Yes, that means we need to roll our sleeves up and get dirty. We must learn, read, and experiment. In the long run, we will build more confidence in our ability to handle our finances. Good Luck!
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