(Adam Levy)
Target date funds can be a great hands-off option for many investors who simply don’t have time to manage their retirement portfolios. All you have to do is select a year in which you expect to retire, and the fund manager will worry about asset allocation. As it ages, the portfolio will shift more assets from stocks to bonds, theoretically leading to a less volatile portfolio.
Target date funds can do a great job of managing a portfolio and ensuring the risk profile is appropriate before retirement. But once you’re retired, they can fall short by allocating too much of the portfolio to bonds.
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A look at the slide path of the target date fund
Changes in asset allocation over time in a portfolio are called slip paths. A target date fund follows a specific glide path, which is usually stated in its prospectus or on the fund company’s website.
For example, Vanguard target date funds invest 90% in stocks and 10% in bonds up to 25 years after the target retirement date. Then, slowly increase the bonus allocation each year until it reaches 50% bonuses and 50% stocks at retirement. It continues to increase the bond exposure over the next seven years until it reaches 70% bonds and 30% equities, which is where it remains for the remainder of the fund’s life.
While there is no standard slippage path for target date funds, most follow a very similar path. Automatic rebalancing for target date funds can benefit many investors who do not have the time, energy or interest to engage in portfolio management. However, there are some major drawbacks to consider.
Target Date Funds Don’t Know Your Other Assets
In retirement planning, it’s important to consider all of your assets and how you can use them to fund your expenses. One of the biggest assets you’ll 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 benefits for 19 1/2 years based on life expectancy at age 65 and the average age people start receiving benefits. That makes the present value of the average Social Security benefit equal to about $295,000 at a 3% discount rate. (Remember, Social Security is adjusted for inflation every year, so the discount rate can be generous.) If you can expect to live longer or earn above average wages during your working career, your Social Security benefits will be worth even more.
Social Security should be considered a fixed income asset. If your $500,000 portfolio is already 50% fixed income assets by the time you retire at age 65, your actual asset allocation may be more than two-thirds of fixed income when accounting for Social Security. And at 72, when the portfolio goes to 70% fixed income, it can be closer to 80% when accounting for Social Security.
That’s not to mention other assets retirees may have, which could include another pension, real estate or a portfolio of securities outside of their retirement accounts. If these are not taken into account, the asset allocation provided by a target date fund may not be suitable for a retiree.
Holding most assets in fixed income is not optimal
Virtually 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 the optimal asset allocation is to use a V-shaped slip path where the bond allocation peaks at retirement age. The portfolio steadily regresses toward a majority portfolio of securities in the first 15 years of retirement before reaching a steady state.
The reason this works is because the sequence of return risk is highest in the first decade or so of retirement. And, not to be morbid, there is also a shrinking timeline for withdrawals. Using the V-shaped slippage path provides increased terminal portfolio value while mitigating sequence of return risk.
Most target date funds continue to increase bond exposure in retirement. And that’s already problematic because Social Security and other assets aren’t counted. But when you add the fact that you’re already putting retirees in too conservative a financial position, it’s grossly suboptimal.
Once you retire, you may have more time and energy to pay attention to your portfolio. You may want to ditch the target-date funds he’s invested in during his career and take a closer look at his financial picture to maximize his wealth and fund a great retirement.
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