The Vanguard Target Retirement Funds are like an automated amusement park ride for investors.

Hand over your money and you’ll start by gliding up the rails of accumulation hill with a thrilling 80/20 equity/bond portfolio. 

You’ll probably do some loop-the-loops during those early years – and maybe even a double-inversion stall – as the market tests your stomach. 

But as the ride progresses, your investment vehicle slackens off the pace. And by the time you’re ready to retire, it’s shifted you to a much gentler 50/50 equity/bond track. 

As you coast down the final decumulation straight, your Target Fund should be about as scary as a kids’ log flume, bobbing along with a 30/70 equity/bond portfolio for a motor. 

Scream if you’ve had enough of this metaphor. 

Vanguard’s target retirement fund in a nutshell

The point is you can be hands-off throughout the journey – except to put cash in or whip it out again, depending on your time of life. 

Vanguards’ Target Retirement Funds are examples of target-date funds, which are designed to help you hit a particular goal (like retirement). Their big benefit is to mostly relieve you of tricky investment decisions such as: 

Asset allocation – You get an oven-ready, globally-diversified portfolio of equities and bonds that takes care of itself. 

Rebalancing – All done as part of the service. That’s a very good thing, as selling your winners and buying your losers is tough to do sometimes. 

Risk management – You start with an aggressive equity load-out when you’re young and have plenty of time to recover from bear markets. You gradually shift to less volatile bonds to protect your gains later on:

This is a perfectly reasonable risk management technique called lifestyling – although we do think having 70% in bonds risks under-powering your retirement. More on that in a minute. 

Underlying holdings – Vanguard Target Retirement Funds invest exclusively in Vanguard’s own passive investor-friendly range of index trackers. We’ve no objection. Other trackers are available but Vanguard has a solid range, and choosing your own is liable to bag you marginal gains, at best. 

Cost – There’s a 0.24% Ongoing Charge Figure (OCF). That’s no longer cheap for a global tracker fund. But it’s good value for a multi-asset fund that does almost everything for you bar filling in the direct debit.

All you have to do is decide when you’re going to retire.

How the target date works

Each Vanguard Target Retirement Fund comes with a target date that identifies the earliest year its investors are expected to retire.

For example, the Vanguard Target Retirement Fund 2030 is aimed at investors who plan to flick the Vs to working life between 2030 and 2034, while the Vanguard Target Retirement Fund 2035 is just the ticket if you’re planning to hold your F.U. party between 2035 and 2039.

On we go in five-year steps out to the impossibly futuristic Vanguard Target Retirement Fund 2065 – by which time The Investor will be tapping out posts with cybernetic fingers and I’ll have been uploaded to the cloud.

You’re a forward-thinking 15-year old who’s already dreaming of life on a Martian golf course from 2070? No doubt Vanguard will soon be releasing a fund for you, too.

The declining glidepath smoothes the way 

It’s the interaction of the target date and the fund’s asset allocation that controls your descent towards a happy retirement. 

The Target Retirement Fund 2030 is 61% in equities at the time of writing, with six years to go until the target date of 2030. 

The fund will be split fifty-fifty in 2030. By 2034 it’ll be 40% equities, then 30% equities in 2037 – seven years after reaching its target date. 

Here’s how each fund comes into land:

The Year of retirement in the graph refers to each fund’s target-date year. 

Vanguard has illustrated a notional retirement age of 68 but you’d still be 50/50 equities/bonds whether you actually choose to retire at age 48 or 78 in 2030 when using the Target Retirement Fund 2030. 

At the start of the journey (left-hand side of the graph) you’ll hold:

• 20% UK equity (red)
• 60% Global equity ex-UK (teal)
• 5% UK nominal bonds (turquoise)
• 15% Global bonds (brown)

Five years before retirement, UK index-linked gilts (orange) also come into play. These should help protect the portfolio from inflation.

By the time the glidepath touches down at age 75 your final asset allocation is:

• 7.5% UK equity (red)
• 22.5% Global equity ex-UK (teal)
• 3.5% UK nominal bonds (turquoise)
• 17.5% UK index-linked gilts (orange)
• 49% Global ex-UK bonds (brown)

Again, all completely sane. 

That said, the convenience you gain by ceding control comes at the cost of making compromises. 

Target Retirement Funds are superb for those who don’t want to manage their own investments, but there are quite a few drawbacks to consider.

For instance…

A rising glidepath may be better for retirees 

An alternative rising glidepath strategy peaks your bond holdings at your retirement age. Thereafter, it allows your equity allocation to rise again while spending down bonds. 

The theory is that maxing out bonds on the eve of your retirement protects you from a hideously bad run of returns (known as sequence of returns risk) that could permanently damage your pension pot. 

After that, holding a larger equity allocation should pay off if stock markets go on to deliver their typical gains. 

If this theory holds then the traditional declining glidepath as followed by Target Retirement Funds is the very opposite of what you should be doing. 

So does it hold?

The best research I’ve read on this topic comes from Early Retirement Now. 

Big ERN concludes that a rising glidepath can help when the market is overvalued when you retire. The improvement is modest but quite consistent when using US long-term historical data. 

So you may turn the retirement dial slightly more in your favour with a rising glidepath strategy. In practice it will depend on your individual circumstances and unknowable future investment returns.

70% bonds in retirement? 

Most research into optimal retirement asset allocations finds against bond holdings as high as 70%. 

Using historical global returns, we found that the higher your equity allocation, the more you could spend from your retirement portfolio. 

That said, there’s reason to believe that historical simulations of retirement spending are somewhat biased against bonds because they oversample from the worst bond bear market in history. 

Moreover, Vanguard’s target-date bond allocations include some corporate bonds. These come with more equity-like risks and rewards.

The Vanguard Target Retirement Fund 2015 holds 15% in corporate bonds1 for example. Its retirement asset allocation can be more properly thought of as 45/55 growth versus defensive assets, rather than a 30/70 split.

Even so, most retirement research suggests you need a much higher equity share than 30% in a decumulation portfolio. 

One way of handling this would be to follow a Target Retirement Fund’s glidepath until you hit the 50/50 mark. Then sell and reinvest your proceeds into a static allocation fund such as Vanguard LifeStrategy.

That way you retain the auto-rebalancing, multi-asset convenience of a target-date fund but you could maintain a 60/40 portfolio for the rest of your days with the LifeStrategy 60 product. 

Risk tolerance

There’s no guarantee that any particular Target Retirement Fund’s asset allocation matches your personal risk appetite. 

Being young is not proof that you can hack an 80% equity allocation.

Theoretically, you’ve got years to recover if things go south. But that’s cold comfort if you freak out and sell during a bear market because you’re in way beyond your risk tolerance.

Of course, you could choose the Target Retirement Fund with the equity/bond mix that best suits your risk tolerance rather than your age. But do take care to check its asset allocation serves your needs as you countdown to retirement.

If you go for a 50/50 split then you may not want to be 30% in equities when the fund powers down seven years later but your retirement is still over a decade away, for example.

Try estimating your risk tolerance or take this test to get a feel for these issues.

Are bonds enough?

Talking of risks, many investors now find it harder to stomach the words ‘bonds’ and ‘safe assets’ breezily rubbing shoulders in the same sentence given the big bond crash of 2022.

Soaring inflation and central banks hiking interest rates as if their keyboard were stuck on the ‘+’ key caused yields to spike up on even the best government bonds that year.

Which simultaneously crashed bond prices.

As a direct result, that calamitous year saw balanced funds that held more bonds actually do worse then those that held more equities – despite share prices falling, too.

That was exactly the opposite of what people thought they were buying when they dialled up their bond allocation.

FT Money editor Claer Barrett in January even described lifestyling as ‘a hidden danger lurking in your pension pot’.

Recounting the case of ‘Martin’, Barrett wrote:

Forced into early retirement after developing a disability, Martin considered what to do with his biggest pension pot. Built up with a former employer, a statement from June 2021 said it was worth nearly £200,000. So he got quite a shock last October when he found its value had plunged to £134,000, wiping nearly one-third off of his pot. How could this have happened?

The answer, as I’m sure most of you have guessed, is lifestyling. As we move towards a more sedate pace of life in retirement, so too do our investments. Unless we say otherwise, money invested in most defined contribution pensions is gradually moved out of equities as we grow older and into bonds and cash, which have traditionally been lower risk investments. However, the dire performance of UK government bonds (gilts) in recent years means they have been anything but.

Tackling this criticism properly requires a full article – watch this space – but the first thing to say is fair enough.

Bonds did do extremely poorly in 2022. It was a generational-level shellacking. Little comfort if you were someone who saw your pension pot plummet just as you entered retirement that there were warning signs, or that equities crash like that far more often.

Especially if you’re a deliberately hands-off passive investor who chose a balanced fund to do the thinking for you. And specifically so you wouldn’t have to make timing calls.

The Monevator house view these days is that a really well-diversified portfolio needs more than bonds. But equally, we don’t think the outcome in 2022 has derailed the case for lifestyling a portfolio.

Mostly it should work well. Nothing will do so in all environments.

Bonds bounce back to life

Anyway, now is a bad time to abandon bonds. That very rare crash has actually boosted the prospects for their future returns.

Vanguard noted in late 2023 that:

The good news is that bond returns have recovered this year and the long-term outlook for bonds is better than it has been for many years.

We expect UK bonds to deliver annualised returns of around 4.4%-5.4% over the next decade, compared with the 0.8%-1.8% 10-year annualised returns we expected at the end of 2021, before the rate-hiking cycle began.

In retrospect, lifestyling was certainly more problematic in the near-zero interest rate era. But so were all our other investing decisions.

Again, would the typical target-date fund customer have done better making market timing calls instead?

I doubt it.

Auto-pilot malfunction 

The final big danger with relying so heavily on Vanguard’s auto-pilot is that you forget to check if you’re still on course before the fund touches down.

Ultimately your fund will need to hit your target number by its target date.

All should be well if:

• Your fund meets or exceeds its expected returns…

• …and you put enough money in…

• …over a long enough period of time.

If performance is falling short then human intervention will be needed to increase your contributions, extend your timeline, or reduce your needs.

Tax efficiency

 A Target Retirement Fund may not be tax efficient if it isn’t entirely sheltered by your ISAs, SIPPs, and personal savings allowance. That’s because bond interest payments are taxed at income tax rates rather than dividend income rates.

Moreover, once your target-date fund’s asset allocation is more than 60% bonds and cash then all of its distributions will be taxed as interest payments rather than dividends. 

• See our post on how bond funds are taxed. 

We still recommend Vanguard Target Retirement Funds 

Despite these qualms, the overwhelmingly massive pro is that the Vanguard Target Retirement Funds are like a self-inflating survival shelter for people who can’t:

• Afford advice
• Learn the ropes
• Stay on top of their portfolio
• Make rational investing decisions

I’ve got lots of friends and family in this camp. And I would happily put every one of them in a Target Retirement Fund.

Any alternative path they’d choose for themselves is likely to be much worse.

Take it steady,

The Accumulator

P.S. Vanguard has occasionally made changes to the US version of the formula in response to market conditions. It increased the equities allocation and also broadened international exposure to equities and bonds. But the UK iterations – launched in December 2015 – have remained largely unchanged.

1. Including securitised bonds. [↩]

What caught my eye this week.

The surge in mortgage costs as millions have rolled-off barely-there fixed-rate mortgages has been a bit of an anti-climax, hasn’t it?

Sure the resultant property market is far from perky. And life is certainly tougher if you’ve had a higher mortgage – or rent – bill to pay, on top of the rest of the cost-of-living crisis

But we’ve not seen a massive nominal house price crash. Let alone a wave of repossessions.

According to an ongoing deep dive by This Is Money this week:

The Bank of England’s latest figures showed the value of outstanding mortgage balances with arrears increased by 9.2% in the three months to December 2023, compared to the previous three month period.

Arrears rose to £20.3 billion, which was 50.3% higher than a year earlier.

The proportion of mortgages that were in arrears increased to 1.23%, which UK Finance says is the highest proportion since the final three months of 2016.

These are leaps to be sure. But they sprang off a very low base.

Overall there are still only 107,000-odd mortgages in arrears. That’s roughly half as many as at the peak of the financial crisis.

Going nowhere

What’s the difference? High employment, I’d say. As long as people have their jobs, they’ll throw everything at their mortgage for as long as they can.

This Is Money cites evidence that savings are being depleted. Some of that may be going on mortgage payments, and that can obviously only go on for so long.

But equally it doesn’t really prove huge stress. Most people who have savings were probably running their budgets with some wriggle room in the first place.

Where I do see stress is in the buy-to-let market.

There’s not been a wave of selling there either, clearly. But I don’t see many people too enthusiastic about becoming new landlords today – and those that are keen are surely being swayed mostly by past performance figures.

Those earlier gains were achieved by a huge escalation in price-to-earnings ratios for property and a historic grind lower in rates. We might see a little of the latter, as rates dip over the next couple of years. But could multiples really go higher?

We’ll see, but right now the numbers don’t stack up – not in London, anyway, despite a population boom.

The flat opposite for me has been looking for a tenant for months. The rent set by the hard-charging Foxtons agency is likely too optimistic. But I still can’t make the yield work for its owner, compared to other places they could invest the money.

Nevertheless with interest rates much more likely to fall than rise following the encouraging inflation figures this week, the UK property market has once again proved to be a mighty end-of-level boss.

People would have – and did – predict carnage in 2022 when rates began to rise.

But the price crash has been in real terms only. And money illusion dulls that pain.

Article errata

I hate having to do this, but unfortunately we published two mistakes this week. They were immediately updated on the web site. But I don’t want to spam anyone’s email inbox with corrected resends, so this will have to do.

By far the most important is that bond funds pay income gross – that is, with no tax deducted.

With my co-blogger The Accumulator away, I took over updating duties for his bond tax article. And I totally missed a change in the legislation some years ago.

On the one hand, this is why we revisit old articles and try to keep them up-to-date. That original article was written in 2015. This tax change alone proves it was long overdue a makeover.

On the other hand, look what happens when the stock-picking guy is let loose near fund stuff. Please lobby The Accumulator to get his priorities’ straight!

At least the second error has his fingerprints on it. Because no, Japan hasn’t posted superior equity returns to the US over the past over however many years. Not even in real terms and after its recent rally.

I suppose @TA was writing under the influence when he let this gremlin through. But I should have spotted it myself, so mea culpa.

We consider getting nerdy investing stuff right a USP of Monevator. Apologies from us both.

Have a great weekend!

[continue reading…]

Okay, there’s no way to sugar this: I’m writing about tax on bonds, so I’ll keep it short, if not exactly sweet.

Bond taxation is confusing and life is fleeting and so – double-quick – here’s what you need to know to keep on the right side of the taxman:

• Bonds are not taxed the same as equities.

• Offshore bond funds are not taxed the same as onshore ones. (In other words, the treatment may be different if your bond fund sits outside the UK.)

• Exchange-Traded Funds (ETFs) are not taxed the same as bond funds.

The following two tables sum up the income tax and capital gains tax treatments and differences between the main types of bond vehicle.

Further explanation lies beneath.

Tax on bonds: interest

	Bond fund (OEIC, Unit Trust)	Bond ETF	Individual gilt	Individual bond
Tax on interest	Income tax rate (e.g. 20%)	Income tax rate	Income tax rate	Income tax rate
Interest paid gross or net of tax	Gross	Gross	Gross	Gross
ISA / SIPP shelter	Exempt	Exempt	Exempt	Exempt

 

Note: Bond funds have paid income gross since 2017.

 

 

Tax on bonds: capital gains

	Bond fund (OEIC, Unit Trust)	Bond ETF	Individual gilt	Individual bond
Capital gains tax (CGT)	Payable	Payable	Exempt	Payable unless a qualifying corporate bond
Non-reporting fund (offshore)	CGT payable at income tax rate	CGT payable at income tax rate	n/a	n/a
ISA / SIPP shelter	Exempt	Exempt	Exempt	Exempt

 

That’s the tax on bond and bond fund sitch in a nutshell.

Now let’s look at the details.

Where should you stash your bonds and bond funds?

If your fund is more than 60% invested in fixed interest and cash at any point during its accounting year then its distributions count as interest payments – not as dividends.

Distributions / excess reportable income will therefore be liable for income tax at your standard rate, rather than softie dividend tax rates.

You can avoid income tax on bonds and bond funds by tucking them away inside your ISA / SIPP – or by being a non-taxpayer.

Since 2017, bond funds registered as OEICs or Unit Trusts pay their income gross – that is, with no tax deducted. A welcome simplification.

The tax rate you’ll pay on bond income will depend on your overall income tax status.

Non-reporting bond funds may pay interest gross. More on non-reporting funds below.

To hold an individual bond in your ISA or SIPP it must be listed on the stock exchange or issued by a listed company. 

Individual gilts are immune from capital gains tax. 

Gilt funds, however, pay tax on capital gains.

Following the great bond rout of 2022 – which scythed through gilt prices – the absence of CGT on individual gilt gains could make holding low-coupon gilts with high redemption yields the most tax-efficient option for you. Do your sums carefully.

Offshore bond funds

If an offshore fund / ETF does not have UK reporting status then capital gains are payable at income tax rates.

That’s bad news because capital gains tax rates are much friendlier than income tax. The £6,000 tax-free capital gains allowance – falling to £3,000 from 6 April 2024 – would count for nought in this instance. And higher-rate taxpayers would pay (income) tax on their capital gains at 40% instead of 20% in CGT.

Make sure your offshore bond tracker says it’s a reporting fund on its factsheet. HMRC also publish a list of reporting funds.

Offshore bond funds / ETFs are subject to withholding tax just like equity funds.

If your bond fund is domiciled in the UK then reporting status and withholding tax isn’t an issue.

Index-linked Gilt ETF vs Index-linked Gilt Fund taxation

Some UK-based index-linked gilt funds are exempt from income tax on the inflationary component of interest payments.

In other words, if inflation shot up 5% in a year and the gilt paid 1% interest on top of that, then you’d only pay income tax on the 1% and not the other 5%.

However, offshore index-linked gilt ETFs will generally impose income tax on the whole interest payment (including the inflation-based element) because they do not enjoy the same exemption as an onshore fund.

So if you’re stocking up with an index-linked gilt fund then look for a tracker fund that’s based in the UK. (Email the provider to make sure they’re packing a tax exemption on inflation-linked interest.)

Take it steady,

The Accumulator

Note: This article on tax on bonds is an updated version of our 2015 original. Comments below may refer to old information, so double-check anything before acting. We’ve left old comments intact as there’s some good tidbits as usual.