The point of this article is not to disparage Target Date Funds. We believe on net they are an important part of the financial landscape and have helped many investors grow their wealth in a balanced portfolio and are glad they are part of the mix. At present, investors have $2.5 trillion invested in Target Date Funds (TDFs), with the majority in 401(k) plans.
However, there are important strengths and weaknesses, appropriate and inappropriate applications of these vehicles of which investors should be aware. Many investors have no idea what is underneath the hood, what the asset allocations are, how much risk they hold. Of course, by necessity they are crude tools. Not everyone retiring in 2030 should have the same portfolio. Each investor has their own goals, objectives, time horizon, circumstances, constraints, and risk tolerance, which TDFs cannot conceivably and simultaneously address.
Last year (2021) Congress began to scrutinize TDFs inquiring specifically about the following[1]:
1. Two questions address risk near the target date. How is risk mitigated and can it withstand market turbulence?
2. What is the asset allocation through time? This is a glide path question.
3. How has the Department of Labor guided TDF selection? This is a standards question.
4. How are TDFs marketed and advertised?
5. What are the goals?
Each of the above questions are important, but because we didn’t want to make this blogpost too long, we will simply address question number one. 401(k) properties LLC took a look at near dated TDFs (i.e. TDFs for people retiring soon) and they found a considerable amount of risk as illustrated in the below graphic. They took a look at two different time periods to see how near dated TDFs would hold up. Those periods were the bear market of 2020 and the 2007-09 Financial Crisis in which near dated TDFs lost 20% and 30% respectively.
Let’s quickly take a look at the Vanguard Target Date 2030 Fund which implies more risk than above and which is designed for someone 8 years from retirement. The allocations for this vehicle are 64% stocks, 35% bonds, 1% cash. This is slightly more aggressive than the standard 60/40 stock/bond portfolio (of which I written more about elsewhere-link: https://bit.ly/3qKAZfh) and the 60/40 is susceptible to a 32.5% drawdown meaning there is the potential for a $1,000,000 in this “balanced” portfolio to drop in value to $675,000.
One of the things these funds don’t do is account for changes in the resilience of the bond component of the portfolio. TDFs assume an aggregate bond portfolio will rise when equities fall and add stability and insurance to one’s portfolio. It turns out these assumptions are not holding as well as they once did and part of the reason is interest rates are historically low, meaning there is more room for them to rise than fall. When interest rates rise, the price of bond fall. As of 3/30/2022, the 20 year US Treasury is down 10.5% year to date and the aggregate bond fund $AGG (proxy for typical TDF investor bond portfolio) is down 6.2% YTD.
Another key point is that not all TDFs are created equal. Each TDF provider (e.g. T Rowe Price, Vanguard, Fidelity) has their own allocations (and thus differing risk levels) for each TDF series (e.g. Target 2015, 2020, 2030, etc). The below graphic illustrates.
While may other insights regarding TDFs could be made, the final point we will make is that TDFs don't adjust to the changing economic and market environment. That may be fine and usually is fine during the majority of the accumulation phase when investors are building their wealth. But as they get closer to retirement and as they enter retirement (advisors often talk about the risk zone being the 5 to 10 years before and after retirement), investors will be best served if they tailor and customize their investment portfolios for their unique situation and in light of the market economic and market environment.
In summary, while we find that TDFs on net are beneficial for investors especially those without professional financial guidance and in the accumulation phase of their lives, it is important to know their strengths and limitations and proper applications. There are places where they are helpful and places where they introduce too musk risk and don’t prepare investors who will soon being to take distributions. For further information, do not hesitate to reach out to us. [1] https://401kspecialistmag.com
About Joshua
Joshua Henry is the founder and Managing Principal of Meridian Financial Advisory, an independent, fee-based wealth management company located in South Carolina, serving people locally and across the country. Meridian focuses on providing wealth management solutions primarily to affluent individuals over age 50 and their families. Joshua is passionate about helping people have a better life by designing and implementing customized financial plans that bring clarity and confidence. Joshua is a CERTIFIED FINANCIAL PLANNER™(CFP®), a Certified Investment Management Analyst® (CIMA®) Professional, and earned a Bachelor of Arts degree in Political Science from Cedarville University and a Master of Business Administration degree with a concentration in Corporate Finance from Salve Regina University. The courses for the Corporate Finance concentration were taken from the Kelley School of Business at Indiana University. He has held workshops on Social Security Claiming Strategies, IRA Planning, and Career Coaching for Executives in between jobs. Josh has also taught finance at the university level. When he’s not working, Josh teaches adult Sunday School at his church in Pawley Island, SC. He enjoys traveling, reading, and time with his family. To learn more about Josh, connect with him on LinkedIn.