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ScaredyCatGuide to the 401(k) - Part 8: Target Date Funds Missing the Mark

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Target date mutual funds, sometimes called lifecycle funds are designed to put your retirement investing on auto-pilot.

TARGET DATE FUNDS – MISSING THE MARK

A general rule of investing is to take on more risk when you are young in an effort to get as much growth as possible. This is usually done by having a portfolio heavy in stocks. Then as retirement nears you tone down the risk by gradually transitioning to fixed income investments, such as bond funds.

The goal of a target date fund is to do this for you. Just pick the year you plan to retire and the fund will allocate your portfolio accordingly. Well, that is what they tell you at least.

Target date funds are one of the fastest growing segments of the mutual fund industry and it is easy to see why. The option for you to “set it and forget it” is enticing. I mean, who wants to deal with rebalancing their 401(k) investments when it can be handled for them.

You have likely seen these funds listed in your 401(k) offerings using names like “Retirement Fund 2030” or “Target 2035 Fund”, for example.

The thing about target date funds is there is no set schedule for the rebalancing of assets. Or let me say it this way, the de-escalation of risk is at the fund manager’s discretion.

The Target Date Time Bomb

What happens if the manager’s rebalancing plan for your target fund fails to meet its objective?

Unfortunately, many people found the answer to this in 2008. I’m left to wonder if the same will hold true for those in 2020 given the current turmoil in the economy.

In 2008 there were a lot of people invested in 2010 target funds. This group was expecting to retire in about two years and had watched the value of their investment grow with the overall market up the past seven years.

It is reasonable to expect with less than two years till the fund met its 2010 target that investment risk would be very low at that point, right? As in, not only would it have very little stock exposure, but even the fixed income investments would be on the conservative side.

However, this was not the case. In fact, it wasn’t even close. All those people getting ready to enjoy retirement in the next year or two suddenly watched their 401(k) accounts drop 20% or more as the stock market crashed from the financial crisis.

So what gives? Based on the advertising of target date funds all of these people likely assumed they did not have much exposure to the stock market anymore. Why did their retirement money cut down so much?

You have probably figured it out by now. The 2010 target date funds still had a high allocation of stocks, which does not exactly bode well for a low risk capital preservation strategy.

It turns out the stock allocation in 2010 target date funds ranged between 40% and 60% in 2008. The “T. Rowe Price Retirement 2010” had a 60% stock allocation for one on the high end while the “Schwab Target 2010” had 41%, according to Morningstar data.

Roughly half of an investor’s retirement wealth was exposed to the whims of the stock market just as they were nearing retirement. If you built up a million dollar next egg over your working career would you want half of it exposed to the fluctuations of the stock market a year before you get ready to retire?

You may be wondering why fund managers would still have such a high allocation to stocks so late in the game. The reasons are myriad, but one driving force is performance.

Performance is the main thing people look at when picking their mutual funds. If a fund isn’t showing good performance relative to its peers or a benchmark then it is less likely to get investment from people, even if the fund is designed to reach a retirement goal in the coming years.

Less investment means less fees, remember the whole percentage of assets cost structure? It also means less people which means less accounts thus leading to less account fees.

It is a vicious cycle, but one that is clearly setup to motivate managers to push the limits in the name of performance. Like the saying goes “no risk, no reward.”

In the end, stocks provide the best chance of growth. They are simply more volatile and outperform bonds over the long-run. The issue is when retirement is near the goal should be capital preservation not maximum growth.

It would be wise to check any target date funds you hold in your 401(k) to see what the asset allocation is relative to your timeline.

Posted Using LeoFinance