In a word - maybe…(Warning: this post will be longer than usual. With these vehicles continuing to gain in popularity, it’s vital that you understand exactly how they work. Grab a cup of coffee, please!)
As with everything else in the investment universe, there are pros and cons. The most appealing feature of TDFs (Target Date Funds) is that they protect investors from themselves. You know my feeling on this. Many individual investors simply do not have the time, patience or persistence to deal effectively with their investments over the long term. It’s confusing and emotional. Many investors get caught up in the latest fad, don’t review their plans enough (or don’t have a plan to begin with) and make rash decisions in the face of big market moves. TDFs, at the very least, provide the illusion of “everything is going to be all right” so people are less like to buy or sell at inopportune times.
So that can be attractive. Here’s an example where TDFs may benefit you quite nicely.
(From T Rowe Price by way of money.usnews.com.)
During the market hysteria from the end of June 2008 to the end of May the next year, only 3.5 percent of target-date investors using T. Rowe Price funds changed their holdings, a rate only a quarter that of holders of non-target-date funds.
Nothing to be sneeze at there…(As you know selling at market lows is the bane of many investor’s existence. Numerous studies have proved that there aren’t that many big days up (plenty of big down days…) and missing the dramatic moves upward will materially reduce your returns.) So it can work out well for you, but if you were retiring shortly after the 2008 debacle, maybe not so good.
For example, T. Rowe Price Retirement 2010 lost 26.7% in 2008, while the average fund geared to those retiring in 2010 declined 22.5% (Forbes.com). Let’s put that in perspective for a moment. If you were invested in one of these funds and entrusted the TDF to protect you with retirement imminent, you got hurt. This is what we call sequence of returns risk. In short, how your investments perform in the few years before and after you retire has a major impact on the longevity of your portfolio.
Sure, some may say that 2008 was a once-in-a-lifetime event, but didn’t we have a nearly identical decline in 2001? (Just sayin…)
A few more pros of Target Date Funds:
1) Better returns than what typical 401K investor experiences
A 2014 study by Financial Engines, an investment-advisory firm, and the consulting firm Aon Hewitt found that investors who used target-date funds earned 3.32 percent more per year than investors who managed investments on their own. That edge would produce a substantially larger nest egg over many years of compounding.
2) Diversification and simplicity.
Within a single fund, you get instant diversification across a wide range of asset classes, which typically include U.S. and foreign stocks, REITs (real estate investment trusts), government bonds, and corporate bonds. This can be a plus for unsophisticated investors who lack the time and energy to diversify their portfolios.
So there is some good. Let’s shift gears for a second and discuss some concerns.
My reservations have to do with a term called glide path. As you may know, a TDF’s asset mix gradually shifts over the years to become more conservative closer to the time you retire. That's the "target date" part. If you're 30 years old today, you might be placed in a 2050 fund, since that year is close to when you will turn 65, the traditional retirement age. (A fund company will typically offer a series of target funds in five-year increments.) (Source: Money Magazine.)
So the idea is for the fund to become more conservative as time goes by but some of the finer details are misunderstood. Case in point...
1) Many investors don’t really understand these things.
There was a landmark study done in which 45% of respondents stated that think that target date funds guarantee them a certain amount of money in retirement. Ouch - that’s not how it works and learning that too late would seriously damper the mood at your retirement party. In the same survey, 20% just weren’t sure about what guarantees the funds made and whatnot.
The second concern or disadvantage has to do with the term I mentioned earlier - glide path. This may be new to you so let’s dig a bit deeper. The purpose of a TDF is for a portfolio to become more conservative as the investor nears retirement (or the target date.). So a 70/30 (Stock/bond) mix might be prudent for a 30 year old but over time this mix is supposed to shift to more bonds and less stocks. However, the specific nuances of each fund’s glide path can be complicated because...
2) All companies have a different way of gliding down the path - if you will. One company may feel that 40% bonds is appropriate for the 2025 fund, while another may go with 60%.
Just look at all the choices from one subset of Fidelity’s offerings. There’s more choices than the buffet at a Vegas casino...
Now consider that there are hundreds upon thousands of these types of funds.
But wait there’s more. As my friend Lance at realinvestmentadvice.com shares, a target date fund may not even have a target at all.
For example, the Vanguard Target Retirement 2020 Fund is designed to increase its exposure to bonds the closer it gets to 2020. Let’s be clear – this is NOT a maturity date, which is part of the confusion of a target-date fund. The target never gets reached. The fund doesn’t go away. It’s always out there.
Also, as a rational human, in 2020, the so-called retirement or target year, wouldn’t you intuitively think this fund should be a conservative allocation? Perhaps 30% equities and 70% fixed income? Well, it all depends on a target date fund’s ‘glide path,’ or method of how the allocation is reshuffled the closer the time to the target date. Every fund group differs in philosophy so you must read the fine print.
For example, the Vanguard Fund takes seven years AFTER 2020 to shift from a 60/40 stock & bond allocation to a 30/70 bond & stock mix. In reality, this is a 2027 fund.
Which brings us to main reason these vehicles scare me for the average Investor especially as he or she nears retirement.
Target date funds don’t consider stock valuations. (I've added BOLD type to emphasize the importance of these words.)
Currently, stock prices are sky-high and the market has been going in only one direction the past 8 years. UP. As I shared with you a few posts ago, It has been more than 1955 days without a 20% correction. The average number of days since 1928 was 635 days before a 20% correction occurred. So we’re due and the lesson from the (2000 - 2002) and (2007 - 2009) periods in history is that the market, despite our hopes and dreams, does not always go up.
Target Date Funds ignore this fact and the closer you are to retirement, the more catastrophic this can be. From our example above: The Vanguard Target Retirement 2020 Fund is still 60% equities in the year 2020, which is presumably when Joe Investor is retiring. As there hasn’t been a correction (or recession) this decade and there is one every decade, an investor in this fund may have a rude awakening as his or her working years conclude. (Or don’t conclude because of the financial need for continued employment.)
This is why two investors can invest the exact same amount of money at the same rate of return for 30 years each but end up with vastly different sums of money. It depends on market cycles. Simply, which 30 year period your money is growing matters!
So the best approach nearing retirement if the market is expensive (and due for correction) is to lighten up on equities no matter what your TDF suggests. (Please Read: Why I’m Taking Chips Off The Table and pay particular attention to my second point about forward investment returns when stock prices are this high.)
Do Target-Date Funds Have a Place in Your Portfolio?
Please take a careful look if you're contemplating or currently invested in a target date fund. Overall I do see some advantages. I certainly recommend TDFs over traditional self-directed individual 401K investing which are a complete disaster in my eyes. (That’s a subject for another day!)
If you do use this vehicle, I might suggest reviewing it more closely as you near retirement. As I mentioned at the outset, there are pros and cons to all retirement products. By being more diligent as the years go by, you might just be able to enjoy the advantages, while mitigating the downside. Not a bad outcome, actually!
I like to say Have A Plan and review your plan yearly. I recently read that 40% of investors would choose to renew their driver’s license, rather than review their game plan for retirement. Interesting! Have you been to the DMV lately.
For you I say No! What I see with my clients, initially, is that they’re afraid of the answer. That they may not have enough assets to enjoy a secure retirement. I also feel that way from time to time. It’s natural; but you must fight on.
Choose a strategy that helps you stay on course year after year and pay particular attention as you near retirement. Autopilot may be good for your Captain on a cross country flight, but it’s not good for retirement planning.
That’s just the way it works!
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This views expressed here are those of (Darryl Rosen) and does not does not take into account your particular investment objectives, financial situation or needs and may not be suitable for all investors. It is not intended to project the performance of any specific investment and is not a solicitation or recommendation of any investment strategy.