Should I Invest In a Target Date Retirement Fund?
Are Target Date Mutual Funds the Holy Grail for Investors? Part 1
Guest contributor; Lawrence J. Russell
Welcome to a comprehensive, two part retirement investing article.
Target date retirement funds are usually “fund-of-funds” investment, which combine stock, bond, cash, and sometimes other investment asset classes. A target fund investor usually buys mutual fund shares, which use the investor’s assets to purchase a collection of other underlying investment funds that are usually sponsored by the same investment fund company.
Thus, target date funds add a layer of management expenses on top of the expenses of these underlying funds. The primary added value of target date funds relates to personal investment asset allocation and purchasing convenience. Over the years, target date retirement funds follow a planned and evolving asset allocation strategy that is designed to prepare for retirement. The target date fund performs annual or more frequent rebalancing and also provides “one-stop shopping” for a specified collection of diversified asset class funds.
Is a Target Date Retirement Fund Appropriate For You?
Would target date funds add value to your investment portfolio? The decision depends upon your answers to a series of questions, which are discussed below. If you have not asked yourself these questions, consider them now, before you buy into any target retirement fund.
Problems With Target Date Retirement Funds
One of the problems with target retirement funds is that they appear to be a simple, complete, and ready-made retirement investment solution that does not require a great deal of thought. The date and the word retirement in the fund names say it all, and this seems to absolve an investor of really understanding how they should be investing for retirement.
Too many naive investors do the following; they simply pick the target date retirement fund name that contains a year in the future that is closest to their planned retirement date. Next they invest in that fund, close their eyes, and hope for the best. They think to themselves that “those professionals” surely know more than I do about this, so I will let them handle everything for me. I certainly hope that there was not something important I should know in that fund prospectus document that I threw away and did not read.
Ask Yourself These Questions Before Investing In a Target Date Retirement Fund
#1: Will your need for higher investment returns and your tolerance for investment risk both decline as you age over your working career and into retirement?
The design of target date retirement funds assumes that earlier in a persons working career they are far more willing and able to take on higher investment risk to achieve potentially higher investment returns. As the investor ages, approaches retirement, and moves into retirement, target date funds will reduce both investment risk exposure and the expected returns of the underlying assets.
While there are nuances to this evolving investment strategy, the big idea is that younger workers farther from retirement will hold a higher proportion of more risky stock or equity assets in their target date retirement fund. As they age, the percentage of stocks will decline, while the percentage allocations to bonds and cash will increase.
While there is a widespread presumption among many individual investors that investment risk tolerance automatically declines with age, this is not necessarily true. Many investors grow more conservative with age and may not wish to take significant investment risks, as they near and live through retirement. However, there is research that suggests one’s risk tolerance remains constant throughout their lives and doesn’t change much. If this is the case, then investors wouldn’t like the greater risk in the earlier years with a diminished risk later. The allocation of funds might not be in line with the investors risk tolerance.
For example, more conservative investors might be uncomfortable with the higher investment risk profile of target date retirement funds that are many years away from the retirement year. Risk intolerant investors may be more comfortable with a lower risk investment strategy during the many decades before retirement.
In contrast, those investors who are much more tolerant of risk may be very satisfied with an asset allocation more heavily skewed toward stocks in the early years. But, they might also be dissatisfied with how the target date fund reduces equity exposure as the retirement date approaches as well as reduces the potential for higher returns in future.
Many aging and older workers are highly tolerant of investment risk. Many more experienced investors understand that they need to be invested all the time to earn securities and stock market risk premiums in the various investment markets.
Barbara’s comment; In fact, my investment portfolio is a bit riskier than might be recommended for an investor my age (which is a secret of course).
Sophisticated and Experienced Investors
Many factors could be in play to counter the assumed tendency of aging workers to become less tolerant of investment risk and more willing to accept lower expected returns. Many older workers have gained long-term experience and have lived through market ups and downs and know how they have reacted. Many have also built up significant assets and realize that sustained long-term savings and long-term asset appreciation have both contributed to their success.
Such successful investors may have accumulated enough so that they could reduce the risk profile of their investment portfolio, but they choose not to do so. Instead, they might be interested in continuing to grow their portfolios in retirement to help their families, make charitable contributions, and build an estate. In addition, if they are concerned about the potential for rising inflation, they might realize that more equity exposure would help to maintain portfolio purchasing power.
#2: Is the “One size fits all” risk-return profile of a Target Date Fund for you?
Investors should understand that their is no one-size-fits-all lifetime investment risk and return model. If you attempt to understand your current tolerance for risk and return expectations, and they happen to fit the current profile of the target date fund that you are evaluating, then you might be a good candidate for investing in that fund. However, you also need to evaluate whether that target date fund’s planned asset allocation model for the future will evolve as you would like it to. If the planned asset allocation model seems right for you, then you might want to purchase this target date retirement fund.
If so, then you should decide whether the convenience of purchasing this target date funds justifies the added layer of fees.
Keep in mind that target date retirement fund asset allocation models change slowly over time. As an alternative, you may be able to purchase the underlying funds directly and make your own customized target date fund at a lower cost.
#3: Do you understand target date retirement fund asset allocation glide paths, and the difference between a target date retirement fund that is “to” versus “through” retirement?
Target date retirement investment funds assume that an investor understands something about asset allocation and re-balancing, and wishes for the equities or stock proportion to decline with age. However, there is significant evidence that many investors do not think clearly about these matters. Instead, they simply invest in a target date retirement fund because of the fund’s name includes a retirement year close to the year of their planned retirement. They do not look more closely under the covers to understand what they actually own. The design of target date retirement funds can differ dramatically from one investment fund vendor to another.
Two Varieties of Target Date Retirement Funds
In general, there are two types of target date funds: A) “to retirement” and B) “through retirement” target date retirement funds. This “to” and “through” difference can lead to significant variability in target date fund outcomes and to great investor confusion. For some background, see this SEC Investor Bulletin on Target Date Retirement Funds.
“To” Target Date Retirement Funds
“To” target date funds attempt to achieve relatively stable value at the point of retirement. A “to” retirement target date fund uses an asset allocation model during working years that result in relatively small equities holdings and relatively large cash and bond holdings at the specified retirement year.
Since the downward equities asset allocation glide path is relatively steep, “to” target date funds must also implicitly presume relatively high savings rates during one’s working years. Nearing retirement with a relatively stable accumulation of investment funds, a “to” retirement target date fund owner could decide to live off the accumulated assets during retirement taking moderate withdrawals. Alternatively, he could decide to annuitize some or all of these accumulated assets in exchange for a steam of fixed payments throughout retirement.
“Through” Target Date Retirement Funds
With a “through” retirement target date fund, the stock proportion of the asset allocation model declines with age but at a more gentle downward slope that passes through the planned retirement age. “Through” target date retirement funds recognize that the investor is expected to live perhaps two or even three decades beyond their planned retirement date. As such, their expected asset accumulation value at retirement can be less stable or assured.
“Through” target date retirement funds hold higher proportions of stock in and during retirement to help the investor sustain the purchasing power of their portfolio over a retirement of uncertain duration.
“To” Versus “Through ” Target Date Retirement Funds
The “to” versus “through” target date funds situation is not a minor nor trivial issue. For example, this was a topic of huge concern in the aftermath of the recent financial crash. When the credit crunch and Great Recession hit and the stock market crashed, some of those who held “through” target date funds were surprised by the drop in their asset values. In particular, many older workers who were nearing their planned retirement age were quite surprised that the value of their target date funds dropped significantly.
This became the subject of some congressional testimony by shocked and naive investors who did not understand what they had purchased. Some investors got so upset that you can go to the SEC website, search for “target date funds” and read for hours what they wrote. If these investors had really understood the glide path of their “through” target date retirement fund, they should have understood that significant declines in value were possible near retirement due to higher equities exposure. Of course, if these uninformed investors had held a “to” target date fund, they would have experienced much less shock at the market crash. Yet these same ill-informed “to” retirement fund investors may have accidentally avoided one shock in exchange for another.
Equities historically offer growth potential and have protected investors from loss of purchasing power far better than cash or bond assets. It is quite possible that many naive investors in “to” retirement” glide path target date funds will experience a slow motion surprise in the future.
If inflation increases and the investor holds few equity assets, their purchasing power could erode over the course of their retirement. Few people accumulate a large enough portfolio before retirement to enable them to live 30 or 40 years on cash and bonds alone.
This article is continued in Part 2, where the questions surrounding “Retirement-Target Date Funds-Taxes; Oh My!” are explored.
Lawrence J. Russell is President and Managing Director of Lawrence Russell and Company, a personal financial planning services provider and registered investment adviser in Pasadena, California. Read his full biography after Part 2, “Will I Have Enough Money To Retire? He is making a significant contribution to the personal finance field through his books, website, and software.
What are your thoughts about target date retirement funds? Would you consider investing in one?