The Dangers of Target Date Retirement Funds - Part 2
Introduction
A few weeks ago we wrote a post about Target Date Retirement Funds and their dangers. You can read that post here. Often, Target Date Retirement Funds will be marketed under other monikers such as Lifecycle Funds, Lifestyle Funds, or Target Date Funds.
Target Date Funds came on the investment scene in the early 2000's. As of 2021 they have amassed a staggering $3.27 trillion dollars in assets. They remain very popular with investors as well as company sponsored retirement plans.
A target date retirement fund is a type of mutual fund that automatically adjusts its investment mix to become less risky as the investor nears retirement.
These types of funds "target" the year the investors want to retire—usually somewhere in your 60s or 70s. Obviously, they will take the investor through many phases of their 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.
The idea of the target date fund makes sense since most investor's who are saving, investing and planning for retirement can choose a product that will do the work for them. These types of investment products offer the investor the promise that all they have to do is invest in their desired retirement date and all will be well in retirement paradise.
What is missing is a Financial Road Map and Plan that determines a whole host of considerations for the investor.
In Part 2 of this special post, we will discuss in detail the shortcomings of Target Date Retirement Funds and how a tailored portfolio that aligns with a financial plan is the key to retirement success.
Retirement Readiness
Let's talk first about a term that you may have read about or heard called Retirement Readiness. Over the last few years, employers have begun to use the term "retirement readiness" when talking about their employees' participation in employer-sponsored retirement plans (such as 401Ks or 403B).
Retirement readiness refers to your ability to maintain the standard of living you have during working years, once you stop earning a paycheck.
This readiness has everything to do with a clearly-defined financial plan and how your hard earned money needs to be invested and allocated so that your lifestyle is maintained and your goals fulfilled. Many investors will invest in a target date type of fund with the hopes that it will make them "retire ready."
The connection between investment and financial plan is a fundamental one. A plan will not only determine the actual dollars that an investor needs in order to retire but also specify their expected rate of return on those assets during their retirement years.
A Target Date Retirement considers none of this as it sets a future date and determines an adjusting allocation usually based on the concept of a glide path.
What is a Glide Path?
A glide path is the way that a fund manager adjusts your investment allocation over time. A glide path is a set of rules that defines how much of your portfolio should be invested in stocks and bonds over time. A fund's glide path may change over time. For example, when you're younger, you may want more risk in order to potentially earn higher returns; as you get closer to retirement age, however, it may make sense to put more money into less risky investments like bonds.
Your mutual fund's glide path will be determined by its objective and investment strategy, which will be outlined in the prospectus. Generally speaking, though, most funds have a target date when they expect you to start withdrawing money from the fund—and that date determines how much of your initial investment you should keep in stocks (growth), how much in bonds (income), and how much in cash or cash equivalents (protection).
The Fallacy of Time Diversification
Glide Paths have a glaring weakness in what investment academics call The Fallacy of Time Diversification. The idea that time diversifies risk is a faulty premise and could have a potentially damaging impact on an investors ability to retire and maintain their standard of living. People often assume that risk increases with age because retirees depend on their investments for income. As a result, many people reduce the percentage of stocks in their portfolios as they near retirement to avoid volatile markets and maximize returns. This is the foundation on which Target Date Retirement Funds are built.
The Science of Asset Allocation and Diversification
When it comes to investing, you will be faced with two terms--Risk and Return. Risk is usually explained in the context of standard deviation. Standard deviation is a statistical measure of how far your investment’s returns are likely to deviate from the mean. The greater the standard deviation, the more volatile an investment tends to be. A low risk portfolio will have a lower standard deviation than a high risk portfolio. Of course, the idea is to create an investment portfolio that will deliver an expected return without the huge swings in volatility.
At the heart of asset allocation is how you can mix various asset components in order to have the maximum amount of return relative to its risk. The answer is diversification. Risk can be reduced by diversifying your portfolio across different investment classes and asset types.
The danger in glide path investing is that simple notion that as you get older, the goal is not simply preserving your capital. This is why Target Date funds have a flaw since they are structured to take a low return approach as you age. Why do we say these funds have a “low return” approach? Because they will have the majority of the portfolio in fixed income (a mixture of government bonds, corporate bonds, and other securitized debt). Almost all fixed income is providing investors with a negative real return in 2022, because inflation is running dramatically higher than the total return that bonds are providing.
Most retirees will live 15-20 years into retirement and will need to make up for lost income and financial needs as they enter their golden years. The glide path model is not designed to do this. In fact, it can be detrimental if you are living off the returns of your investments during retirement. The only way to combat this problem is by diversifying across different asset classes and investment types. This will help ensure that you have options in your portfolio when it comes to generating income during retirement.
A Financial Roadmap and Financial Plan Fixes the Glide Path Problem
As we enter the last quarter of 2022, many investors who are entering retirement or close to it, are faced with high inflation and market volatility. This is not something new as all markets and economies are cyclical and present challenges no matter the era in which one retires. However, a Target Date Retirement product cannot address the challenges that investors are faced with when it comes to rising inflation and market volatility; it assumes that the targeted date will meet the income needs and demands of the investors.
This could be nothing further from the truth. A financial plan and asset allocation strategy can be customized and built based on the specific need of the individual investor. It does not make these types of critical decisions in a vacuum. A prudent plan takes into consideration all of these things so the probability of success will give the investor the confidence that anything that happens, they will be prepared.
Conclusion
For investors who want to eliminate the guesswork of whether or not they will run out of money in retirement and have a plan for success, target date funds are generally not the best solution.
Yes, Target Date Funds are easy and convenient. But if you want to take control of your financial future—and sleep well at night knowing that everything is going according to plan—it's time to ditch the target date funds and start building a portfolio coupled with a detailed financial plan.
A glide path strategy, in and of itself, is not enough to meet your retirement goals. A better approach would be one that takes into account other factors—such as the investment horizon for each asset class.
You can create a financial roadmap that will help you determine the level of risk you're willing to take, as well as how much money you'll need when retirement comes around.
By creating a financial plan and roadmap you can rest assured that you have a portfolio that's built to last and will help you reach your retirement goals.