Do Target Date Funds Miss Their Mark?
- What target date funds are
- One benefit target date funds offer over balanced funds
- Think twice about using target date funds as an automated investing strategy
- Address two issues to minimize risk if you are invested in target date funds
- Target date funds may be more beneficial to the seller than to the investor
What are target date funds, and what is the trend that is behind the birth of these increasingly popular investment vehicles?
Target date funds are mutual funds that invest in a combination of both stocks and bonds. But target date funds are more than “balanced funds" because they offer an additional benefit.
In target date funds, the ratio of stock and bond investments changes “automatically” over time. As you get closer to retirement, the fund becomes more conservative by reducing stock investments and increasing bond investments. After all, when you retire you will not have the security of your salary any longer to make up for losses in the stock market, so you will want more bonds or cash in your portfolio.
Years ago, it was a simple task to pick an investment option under a university retirement plan. There was one custodian to choose from TIAA-CREF, and two investment choices, TIAA Traditional and the CREF Stock Fund. Most university professionals decided to put 50 percent of their contributions into each account for better or worse and rarely looked at it again.
However, over the last 10 to 15 years, the number of investment options offered under university retirement plans have increased dramatically. Now most universities offer additional custodians besides TIAA/CREF (i.e., Fidelity and Vanguard) and all custodians have countless stock and bond funds to select from.
But has this increase in investment options really helped plan participants?
Our market research found that plan participants are often overwhelmed by the sheer number of options from which they are asked to choose. As a result, oftentimes either a combination of bad investment selections are made, or the plan participant picks the “default” alternative offered by the plan sponsor.
Enter target date funds. What could be easier or simpler? All one needs to do is pick a fund geared to your retirement date and that is the end of it. No more tough investment choices to make, no more rebalancing the stock to bond allocation, no more time needs to be spent on investment management.
Once in, you are on automatic pilot, no fuss and no muss. Target date funds are truly the “lazy man’s way to riches!” (If you believe that, I have some swamp land in Florida that you should buy, as well.)
No one wants to make a big mistake with their financials and certainly not with their retirement investments. Having “unintended” risk in one’s investment portfolio is a big mistake that can have serious adverse consequences on your retirement income objective. The following two issues must be addressed if you currently own or are considering investing in a target date fund, or you will be taking on far more risk than you probably intended.
1. ‘To’ retirement or ‘through’ retirement?
Target date funds come in two varieties. One type of target date fund manages your money to your retirement date. The second type manages your money through your retirement date. These two approaches can yield very different returns, and here’s why.
If you retire at age 65 you can expect to live another 25 or 30 years. A target date fund that manages to your retirement date of age 65 will have much more fixed income (bonds) at that date than a fund that manages through your retirement date.
If you are reviewing two funds, and fund A has a 10 percent return, and fund B has an 8 percent return, which is better? That will depend on what you are aiming for, income or growth. You can’t select a fund solely on the highest rate of return. The same is true for target date funds.
The answer to the question of which target date fund is better will depend on what you are aiming for, income or growth. If you are concerned about inflation and not outliving your resources, you will want to find a fund that manages “through” your retirement date. If you want income immediately at your retirement date then you will want a fund that manages “to” your retirement date.
It is also worth noting that, in our experience, many university faculty members do not retire at age 65 for all kinds of reasons. Furthermore, because of tenure, university faculty do not have to retire and, in many instances, they postpone retirement almost indefinitely into the future. This delayed retirement bias should certainly be taken under consideration when selecting any target date fund.
2. Eliminating “unintended risk"
This has to do with changing interest rates and what effect that has on the bond side of the target date fund equation. For the last 30 years we have been in a steadily falling interest rate environment. Interest rates have sunk to their lowest level in 30 years in late 2016, and have rebounded slightly upward since. A rising interest rate environment is bad news for investors who hold long-term U.S. Treasury bonds.
With interest rates trending slightly upward, the outlook for bond investors is not great. Bond values have an inverse relationship with interest rate movements. When interest rates go up, the value of existing bonds go down. How might this rising interest rate trend affect target date fund investors?
In the past, investors could very comfortably transition their portfolios from more aggressive growth models to more conservative income and preservation models by selling stock and buying U.S. Treasury Bonds. The U.S. Treasury Bond paid between 7 percent and 9 percent, or more in some cases, with no repayment risk. This meant complete safety of their principal. Now interest rates on U.S. Treasury Bonds are paying right around 3 percent. And, as mentioned above, as interest rates go up, market values of these 3 percent bonds will decline. So in effect, what used to be considered a very safe asset, U.S. Treasury Bonds, have become a much riskier asset.
What does the charter for the target date fund you are in or are considering allow for bond investments? Some target date funds may allow different types of bonds to be purchased other than U.S. Treasuries; for example, investment grade corporate bonds. The bond side of the target date fund allocation should never be considered risk-free, especially today. Until interest rates get back to more normalized rates, putting money into the wrong kind of bonds can result in negative returns.
One final thought: Target date funds, in all likelihood, will have a greater positive financial impact on the marketer’s pocketbook that came up with the idea for them, than the plan participants who are relying on them to reach their retirement destination. To be successful with investments, one has to do the homework or be prepared to suffer the consequences. And don’t be lulled into complacency because target date funds are offered as the “default” choice in your retirement plan. Being the choice of last resort does not mean that target date funds will work best for you.
Be skeptical of bundled, computer-driven investment models, set on automatic pilot; particularly in this age of black swans. Before diving in, carefully check them out. Just because they are the default choice in your retirement plan, does not mean they will work. If something seems to good to be true, it probably is. Caveat emptor!
By Michael Filbrandt, CLU,® ChFC®, Chairman of the Board, Filbrandt & Company
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