The Problem With Target Date Mutual Funds

It’s a simple story. You plan to retire at a date in the future, say 2025. You invest primarily through your 401K plan at work. At your “target date” for retirement you want an investment vehicle that offers reasonable assurance that funds will be there to meet financial independence goals. Sounds good, right? So you study the fund choices available in your plan and settle on a target date mutual fund that fits your time frame.

 A “target date mutual fund” (TDF) contains a mixture of stocks, bonds, and cash equivalents. The idea is that for a younger person the fund will be more aggressive, with a larger allocation to stocks. As the fund moves toward the target date, the mix gradually changes, becoming more conservative, containing more and more fixed income and less equities. The appeal is “automatic risk management” and hands-off simplicity. The investor hears, “Set it, and forget it.”

  Simplicity sells, as does “no-brainer investing.” A Fox Business News report, 6/24/2014, noted that TDF assets soared to $624 billion in 2013. Part of the growth is attributed to the fact that such funds often are the default option in plans. Employee and employer contributions automatically flow into a TDF if employees do not  make their own choices.

  As an advisor, often I am asked about fund choices within plans, and specifically, what do I think about target date plans? My response: “Don’t tell me when you are going to retire. Tell me when you are going to die?” And if the questioner is married, “Tell me when the surviving spouse is going to die?” How long will your money have to last? There are so many variables in planning for retirement security, that a simple “set it and forget it” solution is not likely to get you where you want to go.

  A 6/17/2014 interview with Ronald J. Surz posted on fiduciarynews.com focused on regulators and problems with target date funds. President of Target Date Solutions in San Clemente, California, Ron Surz is a respected retirement plan consultant and strategist. Mr. Surz pointed out that in the 2008-2009 market slump 2010 target date funds lost 25%-35% of value in 2008. Yes, some market indexes were down more than that but investors on the verge of retirement were shocked. Retirement plan beneficiaries thought their assets were safe and that employers were protecting them by making TDFs available.

 Congress convened hearings on the target date fund debacle but like much in Washington, nothing came of it. In fact, says Surz, “Unfortunately TDFs have actually become riskier at the target date.”

  All target date funds are not the same. Offered by a host of mutual fund companies, funds targeting the same date may have different mixes of stocks, bonds, and cash. Some stock allocations may be more risky than others as fund companies chase performance. Surz observes that bond holdings are more risky in our low interest environment. As interest rates rise, as invariably they will, bonds lose value.

 TDFs ignore “longevity risk,” the possibility of outliving one’s money. If your target date fund largely is in bonds at retirement date, too little risk, and rates of return that are negative after taxes and inflation, could increase, not decrease, the odds of running out of money.

  A comprehensive retirement strategy starts with an analysis of what you think it will cost to live in monthly after-tax dollars? What sources of cash flow exist apart from your portfolio? Pensions, Social Security, working in some form? Once you identify those sources, you can estimate what your portfolio (personal assets plus retirement plan assets) must produce. After figuring in inflation and taxes, is your targeted rate of return (ROR) realistic? How much risk do you need to take to achieve the needed ROR?

 Have you considered health care costs? Do you have long-term care insurance? Will life insurance replace assets at the death of the first spouse, or the second-to-die if a bequest to children or grandchildren is a factor?

  Other, deeper questions should be explored relative to purpose and meaning as you define what “retirement” really means. The point is, planning for what could be a 20-30 year life transition goes beyond simplicities and no-brainer investing. Time, planning, and comprehensive advice are worth the investment!

 Lewis Walker is President of Walker Capital Management, LLC.  Certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC.  lewisw@theinvestmentcoach.com