Voices: Target-date funds are too risky for savers
One of the great financial innovations in recent decades is target date funds. These investment vehicles, which have $2.3 trillion in assets, are intended to be a sort of “set it and forget it” program for investors saving for retirement, automatically shifting one’s asset allocation from aggressive to conservative over time. This might not seem to be all that revolutionary. In the grand scheme of financial innovations, it’s actually a pretty simple idea, but studies show the vast majority of investors are terrible at allocating assets optimally on their own.
The thesis behind target date funds is that the investor outsources his or her asset allocation to a fund manager in exchange for an extra layer of fees that are typically not all that large. In doing so, the investor only has to pick one fund, taking all the brain damage out of investing and having to actively change the allocation between stocks and bonds as retirement approaches. Of course, there is the risk that the target date fund manager gets the asset allocation wrong, given generally accepted assumptions about future equity returns.
My criticism of target date funds is that they are uniformly too aggressive with their equity allocations. Most of them start out with about a 90% allocation to stocks in an investor’s early years, moving toward a 50% allocation as retirement nears. Having 90% of one’s money in stocks is too high in the beginning, and having 50% in stocks is too high at the end. These allocations are a function of the peculiar belief in that stocks are the best way to save for retirement. And even though stocks returned about 8% a year for the last 100 years, we have no knowledge of what they will return in the future, which argues for more diversification across asset classes.
The reason you’re not supposed to have such high allocations to equities is because volatility prods people to make stupid decisions. In a severe bear market, few people who will “hold on” and continue to dollar-cost average as stocks fall. Instead, they usually panic and liquidate their investments at the worst possible time. A target date fund that is predominantly in stocks will have the same effect on people.
When asked to prioritize what services clients want from their advisor, “Maximizing income in retirement” and “help creating a financial plan for my retirement” ranked within the top 3 in a North American survey of advisory clients conducted in early 2020. (2020 Investor Research, Investments & Wealth Institute, April 2020).
The Secure Act’s “RMD hall pass” for surviving beneficiaries requires deft maneuvering to deal with long-term concerns.
At the center is a pledge not to increase rates on those making less than $400,000, and that various changes would only impact earnings above the threshold.
Some personal finance experts say target date funds are not aggressive enough, claiming they could leave investors with lower returns in their later working years and forcing them to retire later. This is bad advice. The whole reason investors should de-risk over time is that as they get closer to retirement, they’re no longer seeking capital appreciation, but rather safety and income. Nobody wants to lose half of their nest egg the year before retirement. There’s no reason someone in their 60s should be in a portfolio of 100% stocks.
The good thing about target date funds is that they force investors to invest in bonds, which they’d otherwise probably avoid altogether. Most individual investors don’t understand bonds, and they invest in fixed-income assets only because someone told them that bonds have some diversification benefits. The problem is that it’s not enough. A 50% allocation to equities for someone in their 60s still leaves someone with a lot of risk right before retirement.
The old rule of thumb was that one’s allocation to bonds should be about equivalent to their age. We don’t hear that advice much anymore because there is a perception that bonds are less attractive these days, owing to record-low interest rates. There are ways to make money in the bond market that don’t involve a dependence on microscopic interest rates. When people refer to bonds in the abstract, most think they are referring to U.S. Treasury securities. But other fixed-income assets, including corporate bonds with below investment grade credit ratings and preferred stock, still offer decent yields relative to the risk-free alternative.
Many target date funds have an allocation to international stocks, which is good, but it would be nice if they had exposure to other asset classes, like certain commodities and even real estate. A target date fund’s returns are often dominated by the stock market, causing much volatility.
Even so, investors are probably happy with their target date allocations. After all, stocks and bonds have both been going up. Plus, it’s just not fashionable to be conservative nowadays. A sustained bear market in stocks might cause asset managers to rethink the assumptions about equity exposure and the glide path. But it would be too late by then.