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The theory behind target date funds is simple and grounded in somewhat uncontroversial financial theory. The idea is that equities have a higher risk profile than government bonds, so younger investors should have a heavier weight in equities and shift more to Treasuries for liquidity purposes as they get older. This can be done in three ways: investors can rebalance themselves, usually on an annual basis, investors can hire a financial advisor to allocate funds accordingly, or they can use an “automated” approach.

The “automated” approach is still somewhat labor intensive, but is often the cheapest and easiest way to go about this. Simply put, investors buy a “target date” fund that has an expiration consistent with their age and financial goals.

Let’s look at the numbers on this—in doing so we are going to create a fake target date fund for a particular generation. Let’s say we start with a cohort born in the year 2000. These youngsters are nearing the end of high school and will be going to college soon, and will probably retire between 2060-2070. That’s a tad older than retirees today, but we will make that assumption because of pressures on Social Security, longer life expectancy, flat wage growth, and so on.

The cohort will probably start working at the end of college and maybe start saving after a year or so on the job. So let’s say they start contributing to a retirement fund at 23—or in 2023.

They’ll want a target fund for 2065 (on average) so this means their money will be in this fund for 42 years. That’s a very long time, but again not unusual for investors.

We’ll also assume contributions raise with inflation and promotions. Wage growth is very weak in America now but is still there at around 2%. Let’s assume that as a smoothed average over the course of our model investor.

We will also assume 5% contributions per year with a starting wage of $28,000. That’s lower than the median but we want to stay conservative.

We’ll also assume no employer-match contributions for the first 10 years because, let’s face it, young people get awful benefits from employers. We’ll assume a 100% match up to 5% after 10 years (again conservative; Baby Boomers would’ve laughed at such an offer in 1975, but this ain’t 1975).

Now how do the numbers look?

Wage Contribution Employer Match
2023 $28,000 $1,400 $0
2024 $28,560 $1,428 $0
2025 $29,131 $1,457 $0
2026 $29,714 $1,486 $0
2027 $30,308 $1,515 $0
2028 $30,914 $1,546 $0
2029 $31,533 $1,577 $0
2030 $32,163 $1,608 $0
2031 $32,806 $1,640 $0
2032 $33,463 $1,673 $0
2033 $34,132 $1,707 $1,707
2034 $34,814 $1,741 $1,741
2035 $35,511 $1,776 $1,776
2036 $36,221 $1,811 $1,811
2037 $36,945 $1,847 $1,847
2038 $37,684 $1,884 $1,884
2039 $38,438 $1,922 $1,922
2040 $39,207 $1,960 $1,960
2041 $39,991 $2,000 $2,000
2042 $40,791 $2,040 $2,040
2043 $41,607 $2,080 $2,080
2045 $42,439 $2,122 $2,122
2046 $43,287 $2,164 $2,164
2047 $44,153 $2,208 $2,208
2048 $45,036 $2,252 $2,252
2049 $45,937 $2,297 $2,297
2050 $46,856 $2,343 $2,343
2051 $47,793 $2,390 $2,390
2052 $48,749 $2,437 $2,437
2053 $49,724 $2,486 $2,486
2054 $50,718 $2,536 $2,536
2055 $51,732 $2,587 $2,587
2056 $52,767 $2,638 $2,638
2057 $53,822 $2,691 $2,691
2058 $54,899 $2,745 $2,745
2059 $55,997 $2,800 $2,800
2060 $57,117 $2,856 $2,856
2061 $58,259 $2,913 $2,913
2062 $59,424 $2,971 $2,971
2063 $60,613 $3,031 $3,031
2064 $61,825 $3,091 $3,091
2065 $63,062 $3,153 $3,153
$90,807 $75,478

A long table, but we see end contributions of $90,807 from the investor and employer match of $75,478. This isn’t enough to retire on in 2017 let alone 2065, but we need to assume returns on these payments will make the end amount significantly more valuable.

However, that isn’t our focus right now. Instead of looking at this from the investor’s perspective, we’re looking at it from the money manager’s perspective. Our job is to allocate those dollars to equities and Treasuries on a sliding scale over time. This time, we’ll give our eyes a rest and look at a graph:

We’re starting with a 77% equity allocation with a 100 basis point decline every year. You can change these strategies and get different allocations and track how much exposure the investor gets to both asset classes over time. You can also take a look at your projected returns and volatility to see how these impact the total balance of the investor at any given point and at the end of the period.

However, those are performance issues and we’re still focused on management. The key here is transaction costs. In the first year the investor is putting $1,078 in stocks and $322 in Treasuries. Transaction costs for stocks vary, but even at just $5 per trade we’re talking about a drag of 0.46% in the first year. This drag goes down over time but the higher drag compounds more, thus making it a bigger drag throughout the period of the investment.

We clearly need a more cost-effective way to invest in our target fund to drive the costs of the fund down. This is where economies of scale come into play. Getting $5 per trade on an investment of $100,000 is not easy, but not impossible. Even if we get a $50 commission on the $100k investment, we’re now talking about a 0.05% transaction cost, so the cost of the transaction is now 53.9 cents!

This is the basic financial logic of mutual funds, ETFs, and so on. As the scale increases the lower costs for initial investors tend to scale as well.

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