2 Problems with Target Date Retirement Funds | Smart Change: Personal Finances
Target date funds can be a great hands-off option for many investors who simply don’t have the time to manage their retirement portfolios. All you have to do is select a year around which you plan to retire, and the fund manager will take care of the asset allocation. As you age, the portfolio will shift more assets from stocks to bonds, theoretically leading to a less volatile portfolio.
Target date funds can do an excellent job of managing a portfolio and ensuring the risk profile is appropriate until retirement. But once you’re retired, they can fail by allocating too much of the portfolio to bonds.
An outline of a target date downsizing plan
Changes in asset allocation over time in a portfolio are called a glide path. A target date fund follows a specified glide path, which is usually listed in its prospectus or on the fund company’s website.
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For example, Vanguard’s target date funds invest 90% in stocks and 10% in bonds for up to 25 years from the target retirement date. Then he slowly increases the bond allocation each year until he reaches 50% bonds and 50% stocks at retirement. It continues to increase bond exposure over the next seven years until it reaches 70% bonds and 30% equities, a level at which it remains throughout the life of the fund. .
Although there is no standard glide path for target date funds, most follow a very similar trajectory. Automatic rebalancing of target date funds can benefit many investors who do not have the time, energy or interest to engage in portfolio management. However, there are some significant downsides to consider.
Target date funds don’t know your other assets
When planning for retirement, it’s important to consider all of your assets and how you might use them to fund your expenses. One of the greatest assets you will have in retirement are your Social Security benefits.
The average monthly Social Security check is $1,669.44. The average person is expected to collect benefits for 19.5 years based on life expectancy at age 65 and the average age at which people start collecting benefits. This makes the present value of the average Social Security benefit equal to about $295,000 at a 3% discount rate. (Remember that Social Security is adjusted for inflation each year, so the discount rate can be generous.) If you can expect to live longer or earn more than the average during your professional career, your social security benefits will be even more valuable.
Social Security should be viewed as a fixed income asset. If your $500,000 portfolio is already 50% fixed income when you retire at age 65, your actual asset allocation may be more than two-thirds fixed income when you retire. accounting for social security. And at age 72, when the portfolio hits 70% fixed income, it may be closer to 80% if you factor in social security.
Not to mention other assets that retirees may hold, including another pension, real estate, or a portfolio of securities outside of their retirement accounts. If these elements are not taken into account, the asset allocation provided by a target date fund may not be suitable for a retiree.
Keeping majority of assets in fixed income is not optimal
Almost all target date funds follow the principle that bonds and other fixed income assets should make up the majority of your portfolio in retirement. In fact, research shows that the optimal asset allocation is to use a V-shaped glide path where bond allocation peaks at retirement age. The portfolio steadily reverts to a majority stock portfolio during the first 15 years of retirement before reaching a steady state.
The reason this works is because the sequence of return risk is highest in the first decade or so of retirement. And, not to be morbid, but there is also a reduced time limit for withdrawals. Using the V-shaped slippage path provides greater terminal portfolio value while mitigating the return risk sequence.
Most target date funds continue to increase bond exposure throughout retirement. And this is already problematic due to the fact that social security and other assets are not taken into account. But when you add the fact that this already puts retirees in an overly conservative financial position, it’s grossly suboptimal.
Once you retire, you may have more time and energy to take care of your portfolio. It may behoove you to ditch the target date funds you’ve invested in over the course of your career and take a closer look at your financial situation to maximize your wealth and fund a great retirement.
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