2 Problems With Target Date Retirement Funds | Smart Change: Personal Finance

(Adam Levy)

Target date funds can be a great hands-off option for many investors who do not have the time to manage their retirement portfolio. All you have to do is choose a year when you expect to retire, and the fund manager will worry about asset allocation. As you get older, the portfolio will transfer more assets from stocks to bonds, leading to a theoretically less volatile portfolio.

Target date funds can do a great job of managing a portfolio and tailoring the risk profile till retirement. But once you’re in retirement, they can be reduced by allocating too much of your portfolio to bonds.

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A Look at the Target Date Fund Glide Path

The change in asset allocation over time in a portfolio is called the glide path. A target date fund follows a specified glide path, which is usually placed in its prospectus or the fund company’s website.

For example, Vanguard’s target date funds invest 90% in equities and 10% in bonds for 25 years from the target retirement date. Then it gradually increases the allocation of bonds each year until it reaches 50% bonds and 50% equities by retirement. It continues to increase exposure to bonds over the next seven years until it reaches 70% bonds and 30% stocks, where it remains for the rest of the fund’s life.

While there is no standard glide path for target date funds, most follow a similar trajectory. Automatic rebalancing for target date funds can benefit many investors who do not have the time, energy, or interest to engage in any amount of portfolio management. However, there are some important drawbacks to consider.

Target date fund doesn’t know about your other assets

In retirement planning, it’s important to consider all of your assets and how you can use them for your expenses. One of the biggest assets you will have in retirement is your Social Security benefits.

The average monthly Social Security check is $1,669.44. The average person is expected to collect their benefits for 19-and-a-half years based on the age at 65 and the average age people start collecting benefits. This makes the present value of the average Social Security benefit equal to approximately $295,000 at a 3% discount rate. (Remember, Social Security is adjusted for inflation each year, so that the discount rate can be generous.) If you can expect to live longer or earn a higher-than-average salary during your working career, your Social Security benefits would be even higher.

Social Security must be considered a fixed income asset. If your $500,000 portfolio is already 50% fixed income assets by the time you retire at 65, your real asset allocation could be more than two-thirds fixed income when accounting for Social Security. And by 72, when the portfolio moves to 70% fixed income, it could be closer to 80% when accounting for Social Security.

Not to mention that other assets retirees may own, which could include another pension, real estate, or a portfolio of securities outside their retirement accounts. If these are not taken into account, the asset allocation provided by the target date fund may not be suitable for a retiree.

Keeping most 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 optimal asset allocation is to use a V-shaped glide path where bond allocation peaks at retirement age. The portfolio moves back rapidly to a majority securities portfolio in the first 15 years of retirement before reaching a stable position.

This is because the order of return risk is highest in the first decade or so of retirement. And, not to be morbid, but also a shrinking timeline for evacuation. The use of a V-shaped glide path provides greater terminal portfolio value while minimizing the sequence of return risk.

Most target date funds continue to increase exposure to bonds during retirement. And this is already problematic because Social Security and other assets are not taken into account. But when you add in the fact that it’s already making retirees too conservative of a financial situation, it’s extremely suboptimal.

Once you retire, you may have more time and energy to focus on your portfolio. It may be worth it for you to drop the target date funds you’ve invested in over the course of your career and take a closer look at your financial picture to maximize your wealth and have a great retirement.

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