Target Date Funds in 401(k)s: Are They Hitting Their Targets?
- A quick history of the 401(k)
- What are target date funds and how do they work?
- Examples and more
- 9 minute read | 39 minutes to listen
Today, anybody in the workforce more than likely participates in their company’s 401(k) retirement plan. Therefore, they should be familiar with an investment option known as a target date fund. While not part of the original 401(k) investing landscape at its inception in 1978, target date funds, launched in 1994, are the most popular way for participants to invest for their retirement future today.
This now dominant 401(k) investment solution generally offers as many as twelve different target date funds. Target dates are structured in increments of 5 years, starting back to 2005 and extending to 2060. Participants simply pick the target date fund closest to the age they believe they want to retire, say age 65. This, of course, raises the question, “Are target date funds a wise investment for retirement?”
Are Target Date Funds Hitting Their Targets?
on America’s Wealth Management Show
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Are Target Date Funds Hitting Their Targets?
Links Mentioned in this Episode
Complimentary Consultation Rebalancing Your 401(k) 401(k) Survival Guide
Dean Barber: Thanks so much for joining us on America’s Wealth Management Show. I’m your host Dean Barber, along with Bud Kasper. Okay, Bud, we are into February here, back in the studio, and we’re going to talk about something today that I believe is a critical topic.
The Problem with 401(k)s
You have the statistic in the article you wrote, Bud, about 80% of companies offer a 401(k) plan. And the problem with the 401(k) plan is the same today as when the 401(k) was initially put into companies, and it was slow to come out. The problem is that the individual investor is most of the time not sophisticated enough to understand what that 401(k) plan holds, what’s it invested in.
The Debut of the Target Date Fund
Something happened. I’m going to call it 15 years ago or so, maybe a little more than that, 16 years ago, target date funds inside retirement plans started to become popular. It was one of these things where it’s like, okay if you don’t know what to choose, look at the date you want to retire and invest your money in that target date retirement fund.
Today we’re going to explore if these target date funds are hitting their targets.
Bud Kasper: Right. Well, that was the purpose of the article I recently wrote on this topic. And you’re right, Dean. It was back in 1994 that we had an introduction of the first target date fund to investors.
Dean Barber: So it’s 27 years now.
Target Date Fund Popularity
Bud Kasper: Yeah. It’s been around longer than you think. But they weren’t popular for the same reason, Dean. I know you remember this because of the longevity that you and I both had in financial planning. I’d go into a company that I was working with that I had a 401(k) with, let’s say, and I’m talking to the employees. And I go, “How are you investing your money?” and so on.
Too many of them at that time, and this is when 401(k)s were in their infancy, target dates were in their infancy as well, and they said, “Well, I haven’t done anything. I got it in money market.” Money market, back then, paying about 4%. “I’m content with that.” I said, “Really? Well, you’re not going to retire, let’s say for another 30 years. I don’t think that 4% is going to get to the amount that you want by the time you reach 60, 65, et cetera.” They had to get a learning curve.
When you think about this, it was almost unfair because now people are being asked to have the knowledge base to create a well asset allocated portfolio at a risk that they may not truly understand. All of that in the hopes of reaching a certain amount of money by the time they need it. And that’s after they’re unemployed.
What are Target Date Funds?
Dean Barber: Well, you and I did a show just last week on many not understanding the amount of risk in their portfolio as a whole, and I think that is even more true in the 401(k) plan. When these target date funds came into play, what they are, by the way, is a fund of funds or a fund of ETFs. If you had the Fidelity target date fund, that will own many different Fidelity funds to give you what they believe, if you’re going to retire at this date, should be the proper asset allocation. Vanguard does it, and American Funds.
Just about all the fund companies have those, right? You even find those in the TSP now, the Thrift Savings Plan, with the federal government or the target date funds. They tried to make it to say; if you’re going to retire at this date, this should be the asset allocation that you have. The question is, does it work? Does it make any sense? Are they hitting their target, or are they falling behind?
Costs Associated with Target Date Funds
Is there an additional cost associated with these target date funds above and beyond the underlying expenses if you just made that mix of funds yourself inside your 401(k) plan?
Bud Kasper: Well, you hit on a very sore point with 401(k) plans and target dates, I should say. And what I mean by that is you had a fee for the creation of the target date funds, which, as you stated, is a fund of funds. But then you had the internal cost of the funds themselves that make up or comprise the target date. That was wrong. It should not have been that way. There is too much expense associated with it, even though it’s what they were doing at the time, “Hey, you’re getting all the management wrapped into one investment.” You’re going to have some costs.
It’s evolved. As time has come by and with the advent of ETFs and things like that, what you’ve seen is they’re not charging very much on the target fund itself, but the internal expenses of the funds they’re using inside the target date are still there.
Picking on Target Date Funds
Dean Barber: All right. I’m going to pick on a couple of things here. And the first thing we’re going to do is look out at a long target date fund. All right? We’re sitting here in 2021, and we’re going to look at a target date fund for somebody who wants to retire in 2050 and a target date fund for somebody who wants to retire in 2055. We would expect that the target date 2055 fund would be slightly more aggressive than the target date 2050 fund.
But if we explore the total return, since both of these funds came into existence in mid-2015, the target date 2050 fund has a total return of 71.22% over that period. The target date 2055 fund has a total return of 70.81%. So the target date ’55 fund returned less. Now, you’re talking about 25 to 35 years out for retirement. Why would I not just own the stock market or an S&P 500 index fund, which most mutual funds have if I’m that age? Over that same period, the S&P 500 index fund would have returned 103.61%.
The Goldilocks Portfolio
So, you’ve got about 33% more money if you just chose the S&P 500. We want to explore why that is. Every single one of you listening right now has what we like to refer to as the Goldilocks portfolio, the portfolio that’s just right for you. The younger you are, the more aggressive you can be, the longer your time horizon is. The closer you get to retirement, five to 10 years out, that’s where the rubber meets the road. That’s where you have to start paying attention.
I want to invite you to schedule a complimentary consultation. There’s a button right there.
You can choose the time that you want to meet with us, and we can visit by phone, virtual meeting, or we can meet in person. Let’s look at what’s going on inside that 401(k) plan. There’s no cost or obligation. It is complimentary.
Other 401(k) Resources
We have a couple of other great articles pertaining to your 401(k) plans. We have a white paper called 401(k) Survival Guide and an article on Rebalancing Your 401(k) written by Jason Newcomer.
Target Date Funds for the Young Investor
So, Bud, we’re asking the question for the younger investor, the investor that will retire in 2055. I mean, you’re talking about 30 to 35 years away.
Now I’ve got my kids that, and you’ve got some of your young adult kids. And when I’m telling them how to allocate their 401(k), I’m saying you want to be in 100% equities. Well, first of all, you don’t have a mountain of money in that 401(k) yet your dollar-cost averaging. So you’re going to catch some lows and some highs. Over time that dollar-cost averaging works, especially when you’re young.
Target Date Funds May Not Be What You Think They Are
I wanted to address the Vanguard 2055 fund and compare that to the S&P 500 because I want people to understand when these are in your 401(k), it may not necessarily be what you think it is. As I said, the total return from mid-2015 through today for the Vanguard 2050 is 71.22%. The 2055 is 70.81%, yet the S&P 500 returned 103.61%.
So if you think about that, you think, okay, well, S&P 500 must be riskier. If we examine year by year returns in 2016, 2017, 2018, 2019, 2020, every single year, the S&P 500 outperformed those target date funds, even in 2018 when there was a loss.
Both of the target date funds lost 7.87 and 7.92%, respectively, while the S&P 500 was down 4.38%. So, which one carries more risk? Why the disparity between those funds that long target versus the S&P 500? The answer is you have to know the asset allocation inside of those target date funds. What do they own?
Know What You Own
Bud Kasper: In fact, that’s what I said in the article, “You need to know what you own. That is a responsibility.” I mean, it’s your money that’s going in on a pretax basis, unless you’re in a Roth, it’s after-tax, but going in on a pretax basis. You most certainly have a vested interest in giving some of your time to understanding how your investments are doing and how you’re creating a portfolio. Let’s face it. Do you remember there was a guy named Ron Popeil? He had the rotisserie oven. It was on TV all the time, and his final pitch was, “Set it and forget it.”
Dean Barber: Yeah, yeah. I remember.
Bud Kasper: “Set it and forget it,” and your meal is ready. In this case, that’s what people are doing with the target date funds. And I’m not saying that’s terrible. I’m just saying there are other options that you might want to add to a target date fund solution or eliminate the target date altogether. In the article, I also stated you could understand how to do this. You have to familiarize yourself with the process.
Understand the Process
Dean Barber: With the lack of knowledge, it’s okay. All right. But if you understand or are willing to work with a financial planner that understands, you can do it better.
Bud Kasper: There you go.
The Truth in Target Date Funds
Dean Barber: Okay. So here’s the truth inside these target dates, 2050 and 2055 funds that we’re talking about now. They own about 37% of the portfolio is invested in international equities. Well, how much of the S&P 500 is in international equities? Zero. They also have-
Bud Kasper: Now, some of the companies do business overseas, but not-
Dean Barber: Some of them are global. We call those a global company, but not necessarily a company that is from another country. We also have about 10.5% in mid cap stocks and about 5% in small cap stocks inside the target date funds.
Then, there’s a combination of investment-grade bonds of about 6% and non-US bonds of about 4%. So they’re carrying about 10% fixed income, 90% equity, but of that 90% equity, only 39% is large cap, the other is mid cap and small cap. And then 37% is in international. So you might think about that and go, well, I’m better diversified.
Now, here’s the thing. There will be periods, Bud, you and I both know this. There will be periods when international will outperform domestic. However, we haven’t seen that in recent years. There will be a period again in the future when it happens.
Well, I would rather be a guy saying, “You know what, international’s making a comeback. Now let’s add some international into my 401(k) plan. And you know what? Small cap and mid cap were doing better than large cap. Let’s reduce the large cap exposure. Let’s increase the mid cap and the small cap exposure.”
Can You Actively Manage?
What people need to be thinking about is, are you smart enough to actively manage? And if you’re not, target date funds might work fine. Are you willing to hire somebody, a CFP®, that understands your entire financial picture and can help you allocate that 401(k) plan in the right way? They get to look at all of your assets, everything that’s outside the 401(k) plan as well. I think there’s a better way than a target date funds, Bud. And that’s just my personal opinion.
Bud Kasper: I understand. One of the things I might add to that is it doesn’t have to be an all or none proposition. You could go in and say, “Well, I’m going to put in the target date fund, 50% of my 401(k) money. And with the other 50% I’m going to explore other opportunities that may exist in the available options on the platform.”
Managing Your 401(k)
You know, Dean, when they first started, and I’m talking about 401(k)s in general, maybe it had six, maybe ten options, but usually not more than that.
Today, most corporations probably have about 50 options. Now, can a person working in a corporation become an expert in each one of those investments? The answer, probably not. Therefore, that’s why you need some counsel from time to time to understand what it is.
And from our perspective, it’s a matter of simply going in and analyzing for you. As you stated, that analysis needs to be accompanied by a financial plan because the whole darn purpose is to get you to the glory road. Part of that is going to be the solutions that you have in your 401(k).
Identifying Your Portfolio Mix
Dean Barber: Well, you’re right. And the only way you’re going to be able to identify how much money you should have in stocks and bonds, what should be international, what should be large cap, small cap, et cetera, is the creation of that financial plan. We use our Guided Retirement System™ to determine that.
One of the things that happens when we use that planning program, Bud, is we see a range. So, your probability of success would be very similar, with only 40% in equities, as it would be at as much as 60% or 65% in equities.
Then, you take that knowledge and say, all right, if we think the markets are frothy; we talked about the markets being overvalued, there’s unrest politically, globally, etc. We want to reduce our equity exposure to 40%, which is where our plan says it gives us the highest probability of success. Well, then reduce it.
Target Date Funds in This Scenario
But if I’m stuck with one of these target date funds, for example, I just pulled up to a target date retirement 2025 fund. Well, that fund is 60% equities, and it’s 40% fixed income. So, if you know that and you think, well, I’d rather have less equities. Don’t just sit there and fall asleep thinking that this fund manager will know your situation. Don’t think that if the markets fall apart, all of a sudden, they’re going to reduce their equity exposure because that’s not going to happen. That’s not what they do.
Bud Kasper: You’re exactly right with that. And people need to understand that there is risk with any investing. That’s why it’s incumbent upon you to understand where your risk lies specifically for our topic today in your 401(k).
Dean Barber: That’s why when we’re building these retirement plans for you, especially those of you that are five to 10 years out from retirement, when we’re looking at your asset allocation, the first thing we’re looking at is generally where most of your money is, which is in your 401(k).
We want to pick out what’s best in there. Then, we can design the rest of your portfolio around that. I want to invite you to get out to our website, read the articles that we’ve written. Particularly, Rebalancing Your 401(k). Pick up a copy of our 401(k) Survival Guide. And while you’re out there, schedule a complimentary consultation.
We can do that consultation through telephone, virtual meeting, or in the office. We’ll look at what you’ve got going on and help you design that 401(k) with the right allocation that’s right for your own situation.
Bud, I want to go into some nightmares that we saw occur with these target date funds back in the great recession that forever altered many people’s retirement.
A Subject for All Ages
Dean Barber: We’re are talking about something that I think pertains to just about everybody that is listening here, whether you’re young or old, whether you’re newly into your career, whether you’re later in your career and close to retirement.
We’re talking about the use of target date funds inside your 401(k) plan and asking the question, are the target date funds hitting their target? And a more pointed question to you, our listener, is, do you even know what those target date funds own?
As we just explored the difference between the target date 2050, the target date 2055, the S&P 500, the disparity in performance, and all those different things. It boiled down to the amount of money in those target date funds in international stocks, small and mid versus just all large-cap.
Target Date Funds for Someone Close to Retirement
So let’s explore this, Bud, for somebody a little bit closer to retirement, but as opposed to putting it into today’s world, let’s fall back to 2007. November 1, 2007, was the high watermark of the bull market that began in early 2002 after the dot com bubble. So talk about it, Bud, because you wrote this article, you did the research here, share with us what you found.
Back to the Future
Bud Kasper: As I said, you have to go back to the future. As you stated, we went back to November 1, 2007, and here we are in a target date fund. Folks, it doesn’t matter what the name is because they’re all going to be pretty darn similar from that. So we’ll just call it the target date fund 2010.
Remember, we’re looking at this from a timeframe of November 1, 2007. We’re in a 2010 target date fund. By the time we went through the great recession, which finished from an investment perspective on March 9th of ’09, the market was down 55.48%. But when we look at this, it was down 36.89%.
Dean Barber: The target date fund was down almost 37%. And you were only two years and one month or two years and two months from your retirement date.
Bud Kasper: Exactly right.
What if Someone Had All Their Money in Target Date Funds?
Dean Barber: Now, what did that do if somebody had all of their money in one of those target date funds and they’re sitting there saying, well, okay, I’m in a target date 2010 fund. So obviously, whoever’s managing that fund knows that I’m going to retire in 2010.
So even if the market falls apart, they’re not going to let me lose a lot of money because they know that I have to have what I have in my 401(k) to be able to retire. And so what happens, you don’t even look, you don’t even open your statement.
You’re just going, yeah. You know, I’m in that target date fund. Everything’s going to be all right. And then when you do open your statement, you’re like, “Oh my God, I just lost a third of what I was planning to retire.” That’s what I said before the break, these target date funds and the people that were using them in the great recession altered their ability to retire and changed everything for them and not in a positive way.
Targeted for Through Retirement Rather Than To Retirement
Bud Kasper: Exactly. Now, here was where the confusion was, Dean. Everybody thought that these dates stood for the date that you would have no risk in the portfolio. In other words, the target date was to the date. What we found out with the Great Recession returns, as ugly as they were, is these were managed through the date.
Well, who’s through date. What date does it end? Yeah, I mean, it’s just as confusing as it could be. Because the anticipation was you take all my risk away by the time I need the money return. Perfect. That’s what I wanted. Boy, this is working out well for me. Well, I’m sorry, because now with this result, we just talked about that 37% decline, guess what? You’re not retiring. Now, you got to work another year or two years and hopefully get that back.
If we were to be fully fair with this, Dean, and we go back in and look what happened from April 1st of ’09, this is after we had the great recession to December 31 of 2010, the market made 46.1%. So you could say, well, it made it back up, but here’s the problem with this.
It should have never had to do that in the first place because now you’re taking more risks than you ever wanted to when you thought you had the target date pegged to the date. Now you have to account for the market’s volatility, this time to the upside, to be able to get you back to where you were back on November 1st, 2007.
The Major Problem
Dean Barber: And herein lies the major problem. The major problem is this. The psychology of the investor would not allow that person to say, “Well, I guess I’m just going to have to wait. What are they going to do? They’re going to go, Oh my God, how far can this thing fall? What is it? What is going to happen? I got to get out of this thing.”
They exist, they go into fixed income at when? The wrong time. And then it might be four or five, six years before they ever recover. The pain was so bad. It’s like, I’m never using that thing again. I don’t want anything to do with the stock market. Look at what happened. I couldn’t sleep at night. I got in a fight with my wife, and it was awful.
Bud Kasper: Yeah, and you’re hitting a lot of points there because you’re right. When you internalize all this, and you take it home, and you look at your wife or your husband and say, “Oh my God, we just lost 37% of our retirement money.” That’s not going to be a happy household for a while, but this is why it’s incumbent upon 401(k) participants to understand what they own.
Once you understand that, now you can start to make alterations yourself. Now here’s another part, Dean. Because these were created so many years ago and because we were looking back then to what the 50 years, excuse me, the 30-year time frame would be.
Now we have to go back and reevaluate. Are we there? In other words, are we tracking the way we should up to the date that we thought was to the date at the end of the target date’s period? Guess what? They still have a 2005 target date, 2010, 2015.
Dean Barber: The problem I have is that you, as the individual investor, have zero control over what they’re putting into those target date funds. You have no say whatsoever. But you do have other options inside your 401(k). There are tools and CFP®, like the financial planners here, that can help you understand how you should allocate your 401(k) portfolio and how it should be allocated on top of the other assets you have outside the 401(k).
But the only way you’re going to know that is by having a comprehensive financial plan done that encompasses all aspects of your financial life. So here’s what I want you to do, don’t guess at this, make sure that you understand what you own, why you own it, and make sure that it’s the right mix for you and your situation.
Learn More About 401(k)s
Dean Barber: I have a couple of articles that I want you to read, Rebalancing Your 401(k) by Jason Newcomer. You can pick up a copy of the 401(k) Survival Guide, but most importantly, schedule a complimentary consultation here. Let’s schedule a time to visit. We can do it by phone. We can do it through a virtual meeting, or we can meet you in the office. However you do it, don’t guess at this. Make sure that you’ve got it nailed down.
Bud Kasper: Again, know what you own, folks, because it’s your retirement. And it is your responsibility. The 401(k) is a bag of tools. How you use those tools in the construction of your retirement house is up to you.
Some Questions to Ask Yourself
Dean Barber: Bud, I’m telling you right now that if you had a good experience in 2019, you had a good experience in 2020. And we know the markets are frothy. This is the time to look at your asset allocation, in your 401(k) and outside your 401(k). Then, ask the questions, “Am I carrying too much risk with where things are in the markets? Should I take a little bit of my winnings off the table? Should I take a lot of my winnings off the table? What should I be doing?”
Bud Kasper: Yes. And in addition to that, and this will carry this forward into the next segment, Dean, is yes, if I’m going to take some risk off the table, should I go into bonds? Is this a good time for the bond market?
Dean Barber: What kind of bonds?
Bud Kasper: Yeah, that’ll be part of the discussion.
Dean Barber: Yeah, because not all bonds are created equal, just like not all stocks are created equal. So if you’re going to own bonds inside that 401(k), maybe you’ve got a guaranteed interest contract inside that 401(k). What do you have? What are your options?
Is it Time?
Is it time to understand what you own inside that 401(k)? Understand what all of your investments are with the markets as frothy as they are today. Is it time to reduce some of the risks in your portfolio? And, is it time to take some of those winnings from the equity positions off the table while the markets are high?
The answer is going to be different for each one of you. We’re not trying to give investment advice by any stretch. We’re trying to educate you and get you to understand that there are times when you want to try to de-risk your portfolio.
There are times when you want to add risk to your portfolio, and this may be one of those times where you want to de-risk it, depending upon where you’re at in your overall life cycle.
For the Younger Investor
For example, if one of my children in their twenties or early thirties was looking at the markets right now and saying, “Dad, what should I do?” I’m going to say, “You know what, keep putting money in. Max that thing out. Get the match. Use the Roth,” and on and on and on, right?
Don’t worry about it because you don’t have enough money in those accounts right now to negatively impact you. And it’s not going to be worth you pulling some money out of the market and missing part of the upside.
For Those Near Retirement
But if somebody is five years out, three years out from retirement, which would be better, a 2% or 3% return in fixed income or a loss of 30 or 40% in the market? And when you’re that close to retirement, you can’t afford to make a mistake.
We gave an example in the last segment, Bud, about the target date 2010 fund from November 2007, through March 2009. Most of those target date 2010 funds were down 35%, 36%, 37%. But they were all close to one another. That’s way too much risk for somebody that close to retirement.
Bud Kasper: Right. And remember the phrase, my 401(k) turned into a 201(k), right? And while that was somewhat humorous, it was quite damaging. The reality of investing hit people right between the eyes.
It’s Your Responsibility
Again, this is why it’s your responsibility to know what you own inside these investments. I don’t expect you to turn into investment experts, but I do expect you to go in and expose yourself to as much as you can so you truly understand what’s going on. Inside these platforms, they’ll tell you what the funds are. You can go inside the funds and look for yourself and see how they’re allocated. How much is in bonds? What kind of bonds? What kind of stocks? Is it going to be a large-cap, or is it going to be a small-cap or mid-cap? Is it going to be value, or is it going to be growth? That’s going to be Greek to a lot of people.
Dean Barber: I know, but what I’m saying is the problem with the 401(k) is that the onus is on the actual employee to make those determinations. Well, if they don’t understand what it is, Bud, how are they going to make the right decision? So that’s why these target date funds became a default investment for a lot of plans. When you sign up, if you don’t know what to choose, they’ll default you into a target date fund based on your age.
Bud Kasper: Right. Predicated on wanting to know what you’re going to be in when you turn 60 or 65, right? So it’s predesigned that way. Now there was some good about that because too many people were putting in and doing nothing. So better that you’re in something that has potential.
Bonds and Risk
Now we’re going to talk a little bit about bonds because you made the point appropriately that 2019 and 2020 were pretty darn good years for stocks. And now the question is, should I take some of my profits? Should I de-risk my portfolio? You better be careful with that, and I think you also have to keep your eyes on the future.
Not necessarily what’s going to transact in the next six months, nine months, one year from that. But when you go in and look at bonds, individual bonds have advantages, and there are lots of radio shows out there that talk about this, “Only buy a bond because you’re going to get your money back when the maturity date is there.”
While that’s true, other opportunities exist, especially inside the ETF. That’s an exchange-traded fund—a format for bonds that is worth exploring. And I can tell you for the clients that we represent, we found some very nice places to pick up some bond income.
Dean Barber: Yeah, but the problem, Bud, is there’s a lot of those that don’t exist inside of the 401(k) plan. You’re usually going to have something that mirrors the bond aggregate—a well-diversified bond fund.
Bud Kasper: Right.
Stocks and Bonds
Dean Barber: Now, let’s back this up just a little bit because the difference between a stock and a bond is a stock represents ownership in a company, and a bond represents a loan to an entity, a company, a government entity, a municipality, or whatever it is.
So when you’re buying a bond, you’re loaning somebody money, and you’re relying on whether or not they have the ability to repay that money with interest over time. When you own a stock, you’re looking at saying, “Okay, I think this company is going to grow. I want to own the company.” So that’s the difference. And another thing that we say in our industry a lot of times is, “Stocks are considered a get rich investment, and bonds are considered a stay rich investment.”
Imagine a teeter-totter, all of us played on a teeter-totter when we were young kids, and you may have young kids or young grandkids right now, and you’re watching them on the teeter-totter. But the thing is that if interest rates are low and interest rates are sitting on one end of that teeter-totter, think about that one teeter-totter being on the ground, well, what does that do to the bond values? Those bond values are now way up in the air.
So if interest rates were to rise, those bond values would start to decline. Now, they will always mature at whatever their par value is, but they could fall below par value at any given point in time, depending upon what current interest rates do. So if you’re going to own bonds inside that 401(k), it’s the same thing with the stocks or the funds. You need to understand what bond options you have.
Bonds in 401(k)s
What’s the duration in the fund that’s in there? What types of bonds they own? Are they high yield bonds? Floating rate bonds? Government bonds or corporate bonds? Mortgage-backed securities? What types of bonds are in there?
The data behind what is inside all of the investments in your 401(k) can be understood. Then the question is, “Do you have the wherewithal independently to understand it?” Because there will be some bonds, Bud, that over the next five to ten years will do well, right, because of where they are today. Then there’s going to be some bonds that will not do well in a rising interest rate environment.
Bud Kasper: Right. And if you go in and look at the fed funds rate at 0.25, and you’re saying, “It can’t go any lower. It’s only going to get higher.” Well, what if the deal goes sideways for a while, and now you’re teeter totter’s balanced in the middle, which means you don’t have the potential for some gains that you had when interest rates were higher and started to fall. And then you have the fear, of course, is that the interest rates begin to rise and your bond values go down. However, you can employ other strategies in the bond market with a higher degree of safety, then perhaps it’s representative of the stock market you can utilize.
Look at Your Total Allocation
Dean Barber: So this is where the importance of looking at your total allocation comes into play. It’s critical because there will be limits in your 401(k) on the types of bonds you can own. Outside, it’s virtually unlimited. So maybe, depending upon your situation, you want to own bonds outside the 401(k), and you want to own your equities inside the 401(k), right? But that’s why when we’re doing financial planning for you, we’re looking at the whole picture.
We understand what your allocation needs to be. And we start with what’s inside the 401(k) so that we can understand that. Then we’ll build on top of that outside the 401(k) plan. We want to look at a total return for all of your money, not comparing what the 401(k) returned versus what did the money you’re able to manage outside that 401(k) do.
Learn About the Roth 401(k)
Bud Kasper: I think people need to become more familiar with the Roth 401(k) option for the obvious reasons. Yes, You’re paying tax on the contribution, but you’re not paying tax when you’re retired, and you’re taking the money out.
Dean Barber: Well, we talk a lot about the Roth 401(k) in our 401(k) Survivor Guide, and of course, you can get that here. You can also read the articles on Rebalancing Your 401(k). Most importantly, schedule a complimentary consultation here. We can visit with you by phone, virtually, or in-person. Whatever is comfortable for you.
Don’t Just Guess
The bottom line here is, don’t guess at this. Don’t just say, “Ah, time takes care of all things.” That’s something your mother told you just to make you feel good. That’s not the case here. That’s not what this is all about. Get that complimentary consultation.
Bud Kasper: Yeah, the opportunity is there. You just have to grab it.
Dean Barber: Well, hopefully, Bud, people have taken what we’ve said today, and they’ve learned something from it. I’m Dean Barber, along with Bud Kasper. Enjoy your day.
A Quick History of the 401(k)
Before we address that question, let’s first understand the history of this savings/investment platform called 401(k). Despite their immense popularity today, 401(k)s had a rather dismal start. It was originally an add-on to Congress’ Revenue Act of 1978. That included a provision that was part of Internal Revenue Code Section 401(k). This part of the code allowed employees of a company to save for retirement by avoiding being taxed on contributions deposited into a personal tax-deferred retirement account on their company’s 401(k) platform.
As stated previously, 401(k)s had a rather difficult start. That said, once contributions could be made directly through the company’s salary withdrawal plan, its popularity grew by leaps and bounds. Today 401(k)s are the most popular way for Americans to save for retirement, with the total amount invested in them around $5.7 trillion.
Target Date Funds
Today a total of 80% of all companies in America offer a 401(k) plan for their employees, and target date funds are an important part of their investment lineup. With the establishment of contributing to a 401(k) through payroll withdrawal making it easier, target date funds have become the dominant choice as an investment solution. In fact, most companies use target date funds as their default investment when an employee elects to participate but hasn’t made an investment selection. The specific target date fund selected by the employer for that employee correlates to the date the employee would turn 65.
At the beginning of 401(k)s, companies turned to Wall Street, insurance companies, and banks to establish investment platforms specific to each company’s 401(k) plan. With these experts’ advice, companies would offer a variety of investments that could be mixed and matched (allocated) in an attempt to allow participants to invest their 401(k) account money the way they wanted.
Realistically, however, most employees may not have or have minimal investing experience and therefore were simply guessing how to invest their contributions. For that reason, the first mutual fund was created in 1924 and popularized in the 1970s. When a new concept called a target date fund came about in 1994, it provided the answer that so many 401(k) participants wanted and, for that matter, needed as a retirement investment solution.
Participants wanted professional management tied to a diversified portfolio of different types of mutual funds targeted to a specific date in the future that the participant wants to retire. A typical 401(k) investment platform generally represents stocks, bonds, and money markets accessed through mutual funds.
At the start, 401(k)s might have somewhere between 6 to 12 investment options (mutual funds) that represented stock and bond solutions. Today’s 401(k)s may have as many as 50 or more investment options. However, the majority of the time, mutual funds or, more recently ETF’s, exchange-traded funds, are part of the 401(k) investment lineup. To explain better, ETFs are generally not managed but do represent the same investment categories of stocks, bonds, and money markets only at less or an expense than the typical mutual fund.
401(k) and Mutual Fund Example
For example, a 401(k) participant might want to invest in a mutual fund of stocks. But what does that mean? Do you want to invest in growth stocks or value stocks? Does the fund invest in large companies (large caps), medium-sized companies (mid-caps), or perhaps smaller companies (small caps)?
The same questions would apply to value stock investing, i.e., small, mid-size, or large cap companies? These same considerations, which represent ways of diversifying one’s stock portfolio, also applies to bond investing. Should one invest part of their 401(k) account in government, corporate, or high yield bonds? Should one invest in short maturity bonds, inteπrmediate, or longer-term bonds.? This same maze of investment solutions also applies to foreign investing. So you can see how challenging and many times overwhelming it is for 401(k) participants to find a diversified investment solution!
The Creation of Target Date Funds
Because of this conundrum of sometimes having not enough or too many investment choices, it was suggested to the mutual fund industry that they should create a simpler investment solution that was diversified, professionally managed for risk and return, and targeted for a specific date in the future! Hence the creation of target date funds.
Defining Target Date Funds
Wikipedia’s definition of a target date fund is defined as a fund targeted to a date in the future where the investment automatically changes the direction of their investments from high risk-high reward to low risk-lower reward as a retiree gets closer to their designated retirement date.
Blackrock, the largest investment company in the USA, defines target date funds as a class of mutual funds or ETF‘s (exchange-traded funds) that periodically rebalances its asset class weightings to optimize both the risk and return for a predetermined time frame in the future, i.e., a targeted retirement date.
Investopedia defines target date funds as a series of mutual funds or exchange-traded funds (ETF’s) structured to grow assets in a way that periodically optimizes both returns and risk for a specific timeframe or target. The structuring of these funds addresses and attempts to optimize an investor’s capital needs for a future date, hence the name target date. Most often, investors use target date funds for targeting a specific date in the future that they want to retire.
These definitions should help 401(k) participants understand how they can invest for a specific year in the future.
Do Target Date Funds Work?
Now that we understand how target date funds work, let’s ask the obvious question, do they work?
The concept behind target date funds is that if you’re 30 years away from retirement (we’re basing this on 2020), you could select a target date fund 2050 for your retirement contributions and possibly company matches. In this example, the target date 2050 fund today would probably be invested between 90% to 100% in stocks. This allocation would likely remain that way for close to 25 years, and then it should start to reallocate by decreasing its stock exposure so that, in theory, there would be little to no exposure to stocks by 2050.
Have Target Date Funds Hit Their Targets?
The answer is we really don’t know since the very first 30-year target date fund won’t hit its targeted date until 2025. We do, however, know that they have experienced considerable volatility in route to their targeted date!
Exploring the Results of a Target Date Fund
Everyone is familiar with the giant mutual fund company Fidelity.
Let’s explore the results of the Fidelity Freedom 2010 Target Date Fund. As we reflect on this particular target date fund’s actual performance, let’s roll “back to the future” to November 1, 2007, when this fund was about three years away from its 2010 target.
This highly regarded, relatively inexpensive, and professionally managed target date fund between November 1, 2007, to March 9, 2009, lost -36.89%! This compares to the S&P 500 stock market index’s result for that same time frame lost -55.48%. Specific to that time frame, the 2010 Freedom Fund captured 66.5% of the S&P 500’s decline for the exact same period.
Did our nearly retired participant expect their Fidelity investment to decline by almost -37%? Of course not, but that’s why we need to understand exactly how all target date funds are allocated at any given point in their specific timeline.
In our review of Fidelity’s 2010 Target Date Fund’s “Great Recession” loss, it took only 17 months for the Fidelity Freedom 2010 Target Date Fund to lose -37% of its value.
Can you imagine the shock that this hypothetical retirement investor experienced now realizing that his/her anticipated retirement savings was cut by over 35%? Where was the management that should reduce risk since it was only three years from its target retirement date of 2010?
Not Just an Isolated Incident
This result, however, was not just specific to Fidelity Target Date Funds. A similar result occurred with Vanguard, American Funds, T. Rowe Price, and many more. The fund industry’s reaction was that the design of the investment strategy was to go past or through the target date, not to the target date. This seems like an obvious misrepresentation. What’s the point of putting a target date on a fund anyway when the industry is now telling it was never their intention to zero out the risk by the December 31st target date?!
To be fair, that same Fidelity Freedom 2010 Target Date Fund invested from April 1, 2009, to December 31, 2010 (what we thought was the target end date) would have regained its previous value thanks to a bull market co-incidentally made +46.1%.
That said, that shouldn’t have happened either. All that meant was that the Fidelity target 2010 would have to have stayed invested in stocks for the entire time between March 9, 2008, to December 31, 2010. That was never the way we as investors understood how target dates funds should work.
A Diverse Portfolio
As we continue our investigation of the structure of target date funds, let’s remember that the basis for the process is to divide the money in the fund between stocks, bonds, and cash. Most retirees understand that the stock market can be volatile. The antithesis of stock market volatility in a target date fund is reallocating the portfolio to have more in bonds and/or money markets and less in stocks in an effort to control the situation.
Bonds and Money Markets
Bonds and money markets we all know are historically safer but provide lower potential returns. Meanwhile, the perception of bonds is that they are a safer investment. Let’s make sure we understand a simple fact. When bond yields rise, the dollar value of that bond will fall in value, and when bond yields fall, the value of bonds should rise.
So with current interest rates today (as of the writing of this article) at 10-year lows and the Federal Reserve pegging the Federal Reserve Fed Funds rate at 0.25%, which direction do you think bond yields will go into the future?
Most certainly, we could build a case that there is the possibility that bond yields may rise in 2021 and beyond. If bond yields increase and you currently own or are considering buying bonds, your bond investment could very well lose money as interest rates rise. Much of this, however, hinges on the type of bonds you may want to invest.
Target Date Funds and Bonds
In target date funds, the determination of what kind of a bond the fund may own, along with the maturity date of those bonds, will determine their potential return as well as their risk. Bond investors may find themselves highly challenged to eke out a positive return in 2021.
Target date funds were built so that professional investment managers will make those determinations. It is also important to remember the old investor axiom, “Know what you own!” So your trust in the target date funds management and their ability to change or alter their allocation at the appropriate time will ultimately determine the fund’s success. That statement has never been more true than now!
Target Date Fund Costs
The last point that investors need to understand is that there are costs for the management of target date funds or, for that matter, investment. Target date funds have expenses. At their inception in 1994, these expenses were somewhat excessive.
In the analysis of internal expenses, you have, of course, the cost of running the target date fund (the management fee), but because target dates are a “fund of funds.” You also have each fund’s expenses. Fortunately for investors, target dates have evolved and are now much less expensive than at their inception. Some are still too pricey, but the best ones have lowered their total annual internal costs nicely. Today, these funds have an average annual price of 0.57%.
Consider All of Your Options
While target date funds seem simple and convenient, and for the most part they are, don’t disregard one’s own ability to create portfolios equal to or better than those constructed by a mutual fund company under a target date title.
It also doesn’t hurt to consider working with a professional financial advisor. Independent advisors who carry the designation CFP®, CERTIFIED FINANCIAL PLANNER™, have gone through rigorous training and testing, and have a college degree from an accredited college or university. They must have a minimum of three years of full time personal financial planning experience and, most importantly, act in the legal capacity of a fiduciary who has successfully passed the rigorous CFP® board exams along with annually required and continuous education.
So, in conclusion, while investing for retirement will always have its challenges, target date funds can be the solution for many future retirees trying to construct or design a meaningful retirement investment strategy.
Bud Kasper, CFP®, AIF® President | Modern Wealth Management Lee’s Summit
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.