The WSJ article Why Target-Date Funds Might Be Inappropriate for Most Investors (free gift article) discusses new research using “deep learning” artificial intelligence to find the optimal asset allocation over time. There are several interesting insights that also agree with common sense. For example, one size doesn’t fit all. Wealthier investors can withstand the volatility from holding a much higher stock allocation, whereas lower net worth investors need to be more conservative to avoid a hitting zero due to a bad sequence of returns.

Here is how the optimal glide path for the average investor differs between Deep Learning analysis vs. actual Target Date Funds:

Though the primary insight of this modeling is that one size doesn’t fit all, the research did reach one conclusion that does apply to all of us on average: The typical glide path used by target-date funds is too conservative starting at the age of 50. In contrast to an equity exposure level that drops to 50% by retirement age and to as low as 30% during retirement, the average recommended equity exposure in the researchers’ model never falls below 60%.

While I don’t know the details regarding the underlying assumptions of this research, the red AI line caught my eye because I also don’t plan on going below about 60% stocks ever in my lifetime. My reasoning is that I am going for a “perpetual withdrawal rate” scenario where my I just live off a base of growing dividends and interest. (I’m not talking about owning only extreme high-yield products like closed-end ETFs, junk bonds, and leveraged REITs). After reaching the “safe withdrawal rate” number that is based on a very high likelihood of not dying with zero, I wanted even more margin of safety. It can be counterintuitive, but over the long run owning businesses can be “safer” than just own a big bag of cash that is constantly exposed to inflation risk.

One of the perpetual debates in retirement planning circles is withdrawal rates, AKA how much monthly income can you take from a portfolio. Once you nail down a withdrawal rate and retirement spending target, then you get Your Number – how much you need to have saved to retire (after backing out Social Security and other income streams). It’s common to start with the static 4% rule, but that rule also includes some drawbacks. An alternative is a flexible withdrawal rule that adjusts based on market returns. When your portfolio grows, you can spend a little more. If it shrinks, you cut back a little. Sounds reasonable, right?

However, I haven’t seen many real-world examples of flexible withdrawal rules. Schwab has helpfully outlined one proposed method in this memo: Lifetime Adjustable Income vs. the 4% Rule: Can You Spend More in Retirement with Less Risk? This provides the underlying basis behind their robo-advisor feature called Intelligent Income where you can pick a comfort level and the software will tell you how much you can withdraw each year and from which type of account (IRA, Roth IRA, taxable, etc).

In this memo, we compare a flexible withdrawal strategy to the static 4% rule. We recommend a lifetime adjustable income strategy, described in this paper, that can be put into action using an annually updated financial plan, using technology or an advisor. Doing so may help increase spending early in, and over a long, retirement and help ensure your money lasts.

Here’s their example structure for flexible withdrawals:

• Set an initial withdrawal rate that delivers an 80% probability of success (savings lasting).
• Adjust spending amounts after each year based on if the probability of savings lasting falls outside the range you decide: here it is below 75% or above 99%. If these thresholds are crossed, increase or decrease spending by the amount that brings the financial plan back to a 99% probability of savings lasting. This results in fewer but more drastic cuts.
• Add “guardrails”. A minimum and maximum acceptable annual (real) spending amount of $25,000 and $60,000, respectively, meaning that we will always withdraw at least $25,000 (or at most $60,000).

Using these flexible rules, the initial withdrawal rate was about $43,000 instead of $40,000. Across all of the simulated scenarios, the average annual withdrawal was basically 20%, or $10,000 a year, higher: $50,000 a year instead of the $40,000 a year (in today’s dollars). Even better, the likelihood of running out of money dropped.

However, you must look past the averages and see that you are now exposed to the extremes. Look at that wide expanse of grey. A significant number of the scenarios involved some extended deep cuts to spending, hitting and hovering just above the $25,000 minimum guardrail. You’ll have to decided if you like this trade-off between probably getting more income but possibly enduring some big cuts. This is why many financially-conservative people would prefer to simply start out at a lower 3% or 3.5% withdrawal rate and adjust upwards if the portfolio keeps growing.

In any case, I found it interesting that Schwab used the probability of portfolio survival rate as the factor used to adjust withdrawal rate. DIY investors can implement a similar system themselves. Here are some tools to estimate portfolio survival probability:

• Vanguard has a very simple one.
• cFIREsim and FIREcalc allow you to enter a variety of variables manually.
• Personal Capital remembers and tracks my actual portfolio and updates this number automatically. That part is free but also offers an optional paid financial advice tier.

Over time, more and more people are seeing the benefits of investing in stocks and bonds through low-cost index funds. Here is a chart from Morningstar showing the overall flow of assets out of actively-managed and into passively-managed US equity funds over the last 15 years.

For a while, people wondered if low-cost digital advisors that managed a portfolio of index funds for a modest fee would take over. The picture looks a little different today.

Wealthfront was one of the early digital-only startups, promising to manage a diversified portfolio of low-cost ETFs for you for a modest 0.25% of assets, even if you had as little as $500 to invest. They tried a few different things over the years, including changing up their model portfolios, trying to add a in-house risk-parity fund, and even recently adding crypto and individual stock options. Their final move came this week, when they announced they would be sold to UBS for $1.4 billion. This wasn’t exactly a huge exit, given the huge amount of venture capital they had burned through over the years. As usual with such acquisitions, they promise both “nothing will change” and “things will only get better”.

In hindsight, I am relieved that I didn’t let Wealthfront handle my assets. They clearly had no firm guiding principles, tweaking their portfolios with each new trend. Based on the reporting, it looks like they sold their customers to the highest bidder, as UBS is not exactly known for low-cost passive investing. This play is widely seen a way for UBS to obtain young investors that will one day be rich (read: one day will generate lots of wealth management fees). See UBS Buys Wealthfront for $1.4 Billion to Reach Rich Young Americans and Why a Bank for the Super Rich Is Taking Aim at the Younger Merely Rich.

Is this move what is best for Wealthfront’s customers? Or what was best for Wealthfront’s investors? Mark the date. I will be checking to see what Wealthfront clients own in 5 and 10 years, if that is still possible. Keep in mind that any portfolio changes usually result in taxable events.

Funds flowed into index funds for a simple reason: they performed better and made folks more money. Index funds performed better primarily due to low costs and low turnover (low tax costs). However, it doesn’t appear that Wealthfront could operate successfully independently while offering low costs. One way or another, the new owners are going to try and extract more money per client either via portfolio changes or higher fee products.

Unfortunately, I worry that even Vanguard, in its pursuit of growth, is gradually going down the same path as many large nonprofits. Many “nonprofits” are huge bureaucracies that chase money as eagerly as any corporation – more money means bigger salaries to management, more political power, and greater career advancement. (Side note: I thought that Vanguard got away with their huge Target Date fund capital gains distribution with little media attention, but now see: Massachusetts investigating sales of target date funds to retail investors after word of surprise tax bills.)

I don’t write much about robo-advisors any more. They showed promise initially, but apparently the business model just isn’t working.

The beginning of the year is a good time to check on the new annual contribution limits to the various available retirement accounts. Our income has been quite variable these last few years, so I regularly adjust the paycheck deferral percentages based on expected income for the year. This SHRM article has a nice summary of 2022 vs. 2021 numbers for most employer-based accounts.

401k/403b Employer-Sponsored Accounts.

For example, I would break down the applicable limit down to monthly and bi-weekly amounts:

• $20,500 annual limit = $1,708 per monthly paycheck.
• $20,500 annual limit = $788 per bi-weekly paycheck.

If you are contributing to a pre-tax account instead of a Roth, you could also use a paycheck calculator to find the detailed impact to your take-home pay.

The higher numbers are for those folks that have the ability to contribute extra money into their 401k accounts on an after-tax basis (and potentially perform an in-service Roth rollover), or those self-employed persons with SEP IRAs or Self-Employed 401k plans.

The investment options in 401k plans have also improved on average steadily over the years with lower fees and costs, allowing your money to compound even faster.

Traditional/Roth IRAs. The annual contribution limits is unchanged from last year, $6,000 with an additional $1,000 allowed for those age 50+.

• $6,000 annual limit = $500 per monthly paycheck.
• $6,000 annual limit = $231 per bi-weekly paycheck.

Most brokerage accounts (Vanguard, Fidelity, M1 Finance) will allow you to set up automatic investments on a weekly, biweekly, or monthly basis. As long as you have enough money in your linked checking account, the broker will transfer the cash over and then invest it on a recurring basis. You may even be able to sync it to take out money the very same or next day as when your paycheck hits.

Health Savings Accounts are often treated as the equivalent of a “Healthcare IRA” due the potential triple tax benefits (tax-deduction on contributions, tax-deferred growth for decades, and tax-free withdrawals towards qualified healthcare expenses). This assumes that you have a high-deductible health insurance plan, you can cover your current healthcare expenses out-of-pocket, you can still afford to contribute to the HSA.

Even though I’ve been parroting the “standard personal finance advice” to raise that contribution percentage and save as much as you can in your 401k for years and years, it still holds true. There is some true mind trickery when the money never touches your bank account. The easiest way for me not to eat potato chips is not the have them in the house. (My nemesis is that Costco mega-sized bag of Himalayan Salt Kettle Chips…) The easiest way to make sure you don’t spend the money that you want to invest, is to never have it touch your bank account.

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.