The Dangers of Target Date Retirement Funds - Part 1
Introduction
Have you ever looked at your 401k and thought, "What the heck am I supposed to do with this?"
If so, you're not alone. Many people are unsure how to best invest their money in a 401k, which is why target date retirement funds were created. A target date retirement fund is a type of mutual fund that's designed to help investors stay on track for retirement by automatically adjusting its investment mix to become more conservative over time.The idea behind target date funds is simple: someone investing in a target date fund will not need to actively manage their investments because the fund will automatically adjust asset allocations over time. The investor simply needs to pick the appropriate target date fund based on when they plan to retire.
Although there are many variations of target date funds, these funds usually invest heavily in equities early in the accumulation phase, and gradually reduce their equity holdings as the target retirement date approaches.
But are they really worth it?
In Part One of this post, we will explore Target Date Retirement Funds, how they are structured and a few things to consider regarding their purpose in a portfolio.
Target Date Funds Have Become the Investment Solution of Choice for Many 401(k) Plans.
The popularity of target date funds has been fueled by the ease with which they can be used. Because they're all-in-one, target date funds do not require investors to make any decisions about asset allocation or rebalancing their portfolios. An investor simply chooses a fund with a retirement year nearest to their personal target year (i.e., 2040) and is then automatically invested in a mix of stocks and bonds based on an algorithmically determined glide path (we will talk about glide path later in this article).
What Are Target Date Retirement Funds?
A target date retirement fund is a type of mutual fund that's designed to help investors stay on track for retirement by automatically adjusting its investment mix to become more conservative over time. It does this by gradually shifting its investments from stocks to bonds over a period of years until retirement.
Target date retirement funds "targets" year for when you retire—usually somewhere in your 60s or 70s. That means that when you invest in one, it's going to be an investment that will take you through many phases of your life, from young adult to middle-aged, and eventually into retirement.
The concept of the target date retirement fund is that it does all the work for you: they adjust their mix of stocks, bonds, and cash over time as they get closer and closer to their final maturity date. They also balance risk and reward so that there are always some years where they have more risk (stocks) and some years where they have less risk (cash). The idea is that on average over time you'll earn better returns than if you were investing on your own. As we have written previously, investor’s who try to go it alone usually end up with dismal returns and missed expectations (see our post on the Dalbar Returns here).
How Do Target Date Retirement Funds Work?
Target date funds use an algorithm called glide path to manage their investments over time. The algorithm uses a formula that factors in the age and risk tolerance of each investor when deciding how much money should be invested in stocks vs bonds at any given time during the investment process.
What is Glide Path?
The glide path is a set of rules used to determine the asset allocation in a target date fund over time. The idea behind the glide path is that investors can choose a fund based on their desired retirement year (i.e., 2035) and then let the fund do all of the work for them by automatically adjusting its portfolio over time. Is there a formula or algorithm that calculates the Glide Path? Yes, there is. The formula is as follows: The fund’s allocation will start at 100% stocks and gradually decrease over time until the target year (i.e., 2035), when the portfolio becomes fully invested in bonds.
Are There Risks to Consider in a Target Date Retirement Fund?
There are several risks associated with target date funds that investors should know about before making a decision to invest in them.
As Investopedia points out, not “all funds are created equal.” The underlying fund holdings and targets differ from product to product. Obviously, there are different views regarding the underlying asset allocation strategy with the target date fund. The underlying holding varies over time. It is difficult to gauge why they differ other than fund manager preference.
The investment style of the target date fund may differ from other relevant target dates due to the actual makeup of the underlying holdings. These proportions will differ over time as the fund matures towards its target date.
Lastly, target date funds will have different expense ratios depending on the fund company and what it is actually investing in regarding the underlying stocks or funds. The reality is that most target date funds are the same funds owned by the company. The reality is that a portfolio allocation strategy can be easily engineered without the need of the target date. We will discuss this in our Part 2 post next week.
Are There PROS to Investing In Target Date Retirement Funds?
Remember the late night television infomercial of Ron Popeil’s RONCO Rotisserie Grill? The catch phrase “Set it and Forget it” became part of the pop culture vernacular. The simple idea was that you could cook an easy meal by using the Rotisserie Grill.
The target date retirement fund is the Ronco “Set it and Forget It” of investing. You can put your hard earned money to work by determining your retirement date and get on with life–never having to worry about your portfolio until you enter your sunset years.
They are often marketed as a one-stop solution for retirement savings, as they purport to keep investors from having to worry about rebalancing their portfolio on a regular basis–it is an easy way to invest for retirement. Often they focus on the following benefits of target date investing.
Automatic rebalancing
The portfolio is automatically rebalanced throughout the year as the fund gets closer to its target date, so you don't have to worry about making changes yourself.
Easy diversification
Target date retirement funds typically have several different asset classes in them (stocks, bonds, etc.), which makes it easy for investors who don't know much about investing on their own to build a diversified portfolio without having to do any research
Other Considerations of Target Date Funds as You Reach Retirement
Generally speaking, the goal in most target date funds (as one reaches retirement) is to reach an allocation of 50% - 60% in stocks at the beginning of retirement, which then gradually shifts towards cash or bond equivalents as the investor ages into retirement. The investor simply needs to pick the appropriate target date fund based on when they plan to retire.
If you are in your 20’s and planning on retiring at age 67, you would find a target date retirement fund that has a future date that aligns with your retirement age. For example, the Vanguard Target Retirement 2060 Fund is made up of close to 90% stock equities and 10% fixed income bonds. They tout the fund as appropriate for investors who:
Have a long-term investment horizon of 10 year or longer;
Are seeking growth as the primary objective;
And can manage the volatility of declines inherent in a stock equity portfolio
Conclusion
Is there a Better Way to Invest for Retirement?
In this article we have explored the basics of Target Date Retirement Funds and highlighted some of the advantages and disadvantages to consider when deciding if a Target Date Retirement Fund is right for you.
Next week we will explore in more detail Target Date Retirement Funds and whether or not they are the best strategy for retirement investing. Can an investor be better served by a more targeted specific approach coupled with a detailed financial road map and plan?
If you have any questions about this article or would like to learn more about how we can help with your retirement investing strategy, please feel free to contact us.