Missing The Target

The problem with target date mutual funds

Photo by Annie Spratt on Unsplash

The concept sounds great…

Select the date you plan to retire, and then invest all your money in a mutual fund targeting that date. The mutual fund company will automatically reduce the risk of the fund as you get closer to your retirement date.

Set it and forget it. What could go wrong?

Target date funds were first introduced in the early 1990s, but they didn’t become popular until the Pension Protection Act was passed in 2006. The PPA allowed for the use of target date funds as qualified default investments within 401(k) and other retirement plans. Employers could automatically enroll new employees into their plan, without any proactive “opting in” on the part of the employee, as long as contributions were made to certain qualified default investments.

As a Financial Planner and Investment Advisor, I am in favor of any vehicle that encourages employees to save more. I do however see three problems with most target date funds.

Problem #1 — what is the appropriate target allocation?

It’s easy to pick a target date for retirement, but once you have selected a date, what is the appropriate asset allocation that a target date fund should have?

Here are three popular target date funds, all targeting the year 2020:

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If we believe the hype, any one of these funds should be appropriate for someone who is working today, and plans on retiring in January 2020 (less than two months from now).

T. Rowe Price says that a 56% allocation to stocks is appropriate, but Charles Schwab says that only a 43% allocation is appropriate. Considering that the average stock mutual fund lost approximately 40% in 2008, if your stock allocation was 13 points higher with T. Rowe Price as compared to Charles Schwab, that could have shaved an extra 5.2% off your total portfolio value that year (40% of 13%).

5.20% might not sound like a lot, but if it meant an extra $52,000 loss on a $1 million 401(k) balance, it definitely stings.

If you planned on working for several more years, a larger decline might not bother you, but what if you were retiring in two months?

It’s beyond the scope of this article for me to argue the merits of a 56% allocation to stocks versus a 43% allocation to stocks. My point is this — ask these three companies what an appropriate allocation is for someone retiring in two months, and you get three different answers.

Problem #2 — are you prepared for the Armageddon years?

In “problem #1” above, I pointed out the wide range of allocations between funds with the same target date. In a year like 2019, when both stocks and bonds are rising, the risk posed by one allocation over another is one of “relative” risk, not “absolute” risk. In other words, the allocation with the greatest stock weighting should have the largest return, but all three funds have increased. If one fund didn’t move up as much as the other, its “relative” return might be lower, but its “absolute” return is still quite high.

Yet, in a year like 2008, the variances between allocations made a huge difference. According to a 2009 report from Ibbotson Associates, there were huge variances in returns between target date funds designed for those retiring in 2010. The best performer of the 2010 funds declined by 3.5% in 2008, but the worst performer declined by 41.3%.¹

What if a decline like 2008 occurred in 2020? Using the current allocation of the Vanguard Target Retirement 2020 Fund, and applying 2008 returns to the underlying asset allocation, the allocation in that fund would have declined by approximately 20% in 2008.

Compared to the 40% decline of the average stock fund, 20% doesn’t sound so bad, but employees have been sold on the idea that target date funds will adjust to become more conservative as they get closer to retirement.

Problem #3 — take it or leave it

While most 401(k) plans offer some form of target date funds for their employees, some employers have opted to only allow target date funds in their plans (or perhaps the target date funds are complemented with only a few traditional mutual funds).

Should you take it or leave it?

For active employees, it still makes sense to invest in your company sponsored 401(k) plan, even if you are forced to select target date funds. The tax deferral on your contributions, along with any company matching funds, can help make up for the lack of customization in the target date funds.

Are there other options?

According to a recent study by Vanguard, 52% of all participants in Vanguard sponsored plans had invested in a single target date fund. By 2023, Vanguard predicts that 80% of their participants will own some form of a target date fund.²

This doesn’t mean that you can only own a single target date fund. Rather than select a single retirement year, if the internal asset allocation of that single fund doesn’t meet your goals, you could invest in multiple target date funds, all with different allocations and retirement years, to better customize your personal asset allocation.

Once you have retired or have otherwise separated from service with your employer, you are no longer obligated to maintain your 401(k) balance in your employer’s plan.

If you are not happy with the investment options provided by your employer, you can rollover your 401(k) to an Individual Retirement Account (IRA), and then you (or your advisor) are free to choose whatever investments you would like.

If you have not yet retired, but you are over the age of 59 ½, many employer plans will allow you to request an “in-service rollover” to your IRA. This allows employees who have reached age 59 ½ the flexibility to take better control of their 401(k) assets, without having to retire and leave their employer first.

If your employer offers the option of in-service rollovers, you can enjoy the best of both worlds. You can maintain your employer plan for your 401(k) contributions each pay period, but you can rollover your existing balance to an IRA where you may be able to take advantage of a more robust list of investment choices.

Retirement isn’t the end of the game, it’s the beginning of the second half

Photo by Charlotte Karlsen on Unsplash

What bothers me most with target date funds is that the investing world is suggesting to employees that retirement is the finish line. You made it. You’re done.

That oversimplification can be dangerous. Retirement is not the end of the game, it’s the beginning of the second half. If a couple retirees at age 60, there is a very good chance that one of them will live until age 90 or beyond. It’s important that your investment allocation consider “longevity” risk in addition to “financial” risk, which is something most target date funds seem to miss.

Every 60-year-old I’ve met has many dreams and aspirations for how they would like to spend their retirement years, and it is important that your investment plan can keep up.

About the author

William B. Burns, Jr. CFP® is a CERTIFIED FINANCIAL PLANNER professional and President of Burns Matteson Capital Management, a Financial Planning and Investment Advisory Firm with clients throughout the United States. He helps high-net-worth families reduce the worry and anxiety sometimes associated with wealth, allowing families to reclaim that time to reinvest back into their family, social, and professional relationships. www.BurnsMatteson.com

William B. Burns, Jr., CFP®

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Bill is a CERTIFIED FINANCIAL PLANNER professional with Burns Matteson Capital Management, a Registered Investment Advisory Firm with clients throughout the US.

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