Target date funds can be a great hands-off option for many investors who don’t have time to manage their retirement portfolios. All you have to do is pick a year around when you expect to retire, and the fund manager will worry about the asset allocation. As you get older, 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 that the risk profile is appropriate until retirement. But once you retire, you can fall short by allocating a lot of the portfolio to bonds.
A look at the sliding trajectory of the target date fund
Changes in asset allocation over time in a portfolio is called a slip path. A target date fund follows a specific path that is usually laid out in the prospectus or the fund company’s website.
For example, target date Vanguard funds invest 90% in stocks and 10% in bonds up to 25 years from your target retirement date. He then slowly increases the bond allocation each year until he reaches 50% of the bonds and 50% of the stock with retirement. It continues to increase bond exposure over the next seven years until it reaches 70% bonds and 30% equity, which is where it remains for the rest of the fund’s life.
Although there is no standard sliding path for target date money, most of them follow a very similar path. Automatic rebalancing of target date funds can benefit many investors who do not have the time, energy or interest to engage in any amount of portfolio management. However, there are some important drawbacks to consider.
Target date funds don’t know about your other assets
In retirement planning, it’s important to consider all of your assets and how you can use them to fund your spending. 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 receive benefits for 19 and a half years based on a life expectancy of 65 years and the average age beginning to collect 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 adjusts for inflation each year, so the discount rate may be generous.) If you expect to live longer or earn a higher-than-average salary during your career, your Social Security benefits will be more valuable.
Social Security should be considered a fixed income asset. If your $500,000 portfolio already represents 50% of your fixed income assets by the time you retire at age 65, your actual asset allocation may be more than two-thirds of your fixed income when calculating Social Security. And by the year 72, when the portfolio goes to 70% of fixed income, it could be closer to 80% when calculating Social Security.
Not to mention other assets retirees may have, which could include another pension, real estate or a portfolio of stock outside of their retirement accounts. If this is not taken into account, the asset allocation provided by the Target Date Fund may not be suitable for retirees.
Maintaining the majority of assets in fixed income is not optimal
Pretty much 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 sliding trajectory where bond allocation peaks at retirement age. The portfolio declines steadily toward the majority stock portfolio in the first 15 years of retirement before reaching a stable state.
The reason this works is because the risk-return sequence is highest in the first decade or so of retirement. And not to be annoying, but there is also a shrinking schedule for withdrawals. The use of a V-shaped slip path provides greater value to the final portfolio while mitigating the sequence of return risks.
Most target date funds continue to increase their exposure to bonds throughout retirement. This is already problematic due to the fact that Social Security and other assets are not taken into account. But when you add in the fact that it actually puts retirees in a very conservative financial position, that’s very sub-optimal.
Once you retire, you may have more time and energy to pay attention to your wallet. You may have to let go of the target date money you invested in during your career and take a closer look at your financial picture in order to maximize your wealth and fund a great retirement.
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