If you worked for a large company and participated in their 401(k), 403(b) or 457 retirement plans, they may have put you in one of their Target-Date Funds. This type of fund uses your projected retirement date as a “target,” and works backwards. When you are young and many years away from retirement, the asset allocation is more growth-oriented. Every few years, as you get closer to retirement, the fund adjusts its asset allocation to gradually become more conservative (i.e., a greater proportion of bonds to stocks). The reasoning is that as retirement approaches, you want a more defensive stance in case the market goes down just when you’re about to retire. For this reason, target-date funds have become a popular choice when you’re in the accumulation phase of your life. About half of all 401(k) participants now use target-date funds, according to the Investment Company Institute. But is leaving your retirement nest egg in target-date funds the best choice after you leave your job?
A strategy for accumulating money for retirement can be very different from the one you use once you’re in retirement. A target-date fund can be very appropriate for accumulation because it runs by itself and you don’t have to think about it — it’s like being on auto-pilot.
However, once you retire, everyone has different goals — some people want to catch up on travel and need a lot of income in the first several years of retirement; some people retire early and need to maintain the growth of their retirement nest egg in order to fund 25 to 30 years of retirement; some are fortunate to have more than enough income and assets, and can put all the retirement money in the bank.
Target-date funds, on the other hand, are one-size-fits-all. The target-date fund picks an allocation that it thinks is “right” for the average person. One of the largest target-date funds holds only 38% in stocks at the retirement date. This might be too conservative for those employees who retire early, or whose families are very long-lived, because they need the money to keep growing in order to not run out of money in retirement.
Most employees don’t look “under the hood” at their target-date fund to see what mutual funds and asset classes are actually in the portfolio. They might be surprised if they did. There are over 15 different asset classes that make up a broad, globally-diversified portfolio. We have seen many target-date funds that are quite skimpy, and completely exclude U.S. small companies or international investments. In a year like 2016 when the Russell 2000 small cap index went up 19.5%¹, the omission of an asset class can significantly hurt performance.
There are also conflicts of interest in target-date funds. The brokers who sell 401(k)s to companies often fill up the target-date fund with mutual funds that offer more compensation to the broker, or make more money for the investment management firm that puts together the 401(k) plan. The investor has no discretion over the choice of those funds.
What may be one of the most important deficiencies of target-date funds is their inability to enhance growth through quarterly rebalancing. In a globally-diversified portfolio, not all of the asset classes go up at the same time — they tend to take turns. You can take advantage of this characteristic by reviewing the performance quarterly, and selling a little of what made the most gains, and putting the proceeds from the sale into another part of your allocation that represents a bargain at the time. By doing this, you are buying low and selling high every 3 months. Just doing regular rebalancing can make a big difference in long-term performance.
The problem is that target-date funds are locked into a particular allocation. Any withdrawals are made proportionately across all of the fund’s assets. You cannot buy or sell just a particular component within a target date fund. Consequently, quarterly rebalancing is not possible.
The limitations of target-date funds exist not because of bad design, but because target-date funds were meant for the accumulation phase of your life. They weren’t intended for efficient withdrawals and growth after you retire. They expected that when employees retire, they would move their assets from their 401(k), 403(b) or 457 plan to an Individual Retirement Account (IRA). Not only would the transfer be tax-free, but the tax-deferred growth would continue. The retiree would then benefit from more investment choices than were available in the employer-sponsored plan, greater control and customization, and potentially better performance through lower investment costs.
Once you’re retired, you can work with a fiduciary, like a Certified Financial Planner or CPA, who is required to act in your best interests. They can help you create an IRA tailored to accomplish your particular goals. Having the right IRA will help your retirement assets grow to keep pace with inflation, provide income for your lifetime, and pass remaining assets to your children and grandchildren through Inherited IRAs.
¹ Morningstar