Target-Date Funds Under Fire

The Securities Exchange Commission and Department of Labor are taking aim at target-date retirement funds. This is a fight worth watching because target-date funds are a great way to save yourself from yourself when it comes to building your retirement nest egg.

If you are new to target-date funds, the best way to think about them is as the financial version of the chicken rotisserie set-it-and-forget-it machine. These mutual funds have names like “Target Date 2010” or “Target Date 2035.”  The idea is that you invest in a fund that has a “vintage year” close to when you turn age 65.  Then, as you get closer to retirement, the company managing the fund will gradually shift its mix from stocks, to bonds, to cash – to ensure that your asset allocation is appropriate for your stage in life.

Alas, it turns out that mutual fund companies all have their own idea of what an “ideal” portfolio should look like for someone who is turning 65 in say 2010.   According to Morningstar data, the percentage of stocks in target date 2010 funds has ranged from roughly 20% all the way up to 80%. That’s entirely too much variability.

I’ve always liked the simplicity of target-date retirement funds and want to see them thrive. So what should we be rooting for Washington to do? My favorite rule of thumb comes from Vanguard’s founder, John Bogle. He says that the percent of your portfolio that should be in bonds is equivalent to your age. Another way to say this is that the maximum percent of your portfolio that should be in stocks is 100 minus your age (so if you are 60 years old, 100 minus 60 equals 40, and thus 40% is the maximum percent of your investible assets to have in stocks). Personally, I like to tweak this rule for gender. That’s because women statistically live an average of 7 years longer than men. So I like to say that if you are a male, the maximum percent of your portfolio that is in stocks is 100 minus your age… and if you are a woman, that equation shifts to 110 minus your age.

In this day and age of financial shenanigans, some oversight of target-date funds is a good thing. My fingers are crossed, however, that any guidelines that are adopted will be in line with Mr. Bogle’s sensible suggestions.

3 Replies to “Target-Date Funds Under Fire”

  1. Hi Manisha,
    Thanks for bringing light to this subject. I have a question that I’m hoping you might be able to clarify along these lines.
    We’ve all seen the growth curve that many financial advisors offer where “the longer your money is invested, the more earning potential it has” and the visual chart that accompanies that showing that in the latter years your investments grow at a much quicker pace than in your younger years.
    Here’s my question – can you better explain the stand that some advisors take that target date funds are bad? I’ve heard it explain that if you shift your portfolio as you grow older, you are eliminating the signficant growth opportunity that exists and that your growth chart will look significantly stunted from what many use as an industry standard.
    What are your thoughts on this?

    1. Hi Kevin,
      The root problem with the argument put forth by “anti-target-date-fund-advisers” is that they assume their clients will behave rationally at all times. During my 15 years in the financial services industry, I found that more often than not clients behave… like humans. Humans have a tendency to get scared during turbulent market periods (when we should be brave) and we get greedy during periods of market euphoria (when we should be skeptical).
      The charts that show the awesome power of compounding are mathematically correct. If you have a magic $100 bill that doubles every 10 years (for an implied annual return of 7.2%), you’d have the following growth in your assets:
      Year 0 – $100
      Year 10 – $200
      Year 20 – $400
      Year 30 – $800
      Year 40 – $1,600
      Year 50 – $3,200
      … so, absolutely, that last doubling is where the big wealth kicks in. The problem is that markets don’t move in smooth lines. Over the past 80 years, markets have had negative returns in over 1 out of every 4 years. That means when you get to that point of the last doubling, you may be in a period where the market is down 20%, 30%, 40% or more. And thus you may not get that last double – you may be in a period like last year when markets were down substantially. That, in turn, can cause people to make very rash decisions – like pulling all their money out of the market entirely. The advisers who state that shifting from stocks into bonds as you get older eliminates the possibility for significant upside are absolutely correct… but they are neglecting to mention that such a move also helps prevent the possibility of significant downside as well.
      That’s the benefit, from my perspective, of a target-date fund. It gives you a less bumpy ride – and is particularly powerful for people who start saving early on in life so that they have more time for those “stock doubles” to occur before the asset shift from equities into fixed income.
      Thanks for the thought-provoking question and hope this response was useful!
      All my best,
      Manisha

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