In the golden old days, employees typically received pensions when they retired (defined benefit plans). Based on the work history and salary, they received a fixed payout from their employer when they reached retirement age. So, they got a predictable income stream and the risk was on their employer to provide the amount promised. They hired experts to fund and manage pension accounts and the risks were spread amongst all employees and all years.
Defined contribution plans (401-K, 403-B, Simple IRA, etc.) are now the way of the world. What you and your employer put into the plan might be defined, but what you have when you retire is unknown and all risks are on your plate rather than your employer’s. We can argue about the merits of this forever, but….it is a done deal and very unlikely to change. Employees as a group are not knowledgeable investors nor are they currently saving at an adequate rate for retirement. To deal with plan participant’s lack of investing acumen, the financial services industry has developed and promoted Target Date Funds.
Rather than a participant figuring out what investments they should own, they merely choose a fund with a target date similar to their assumed retirement date. Then, the mutual fund company manages the Target Date fund, following a “glide path” in which the fund slowly becomes more fixed income and less stock based as you approach retirement.
Do you like a “one size fits all” wardrobe? We prefer to find shoes and clothes that fit us personally. The Target Date Fund is strictly a one size fits all solution to your retirement.
The problems with these solutions fit mostly into two basic areas. The first is in treating all workers the same. Let’s say you are 55 years old and have done a tremendous job saving for retirement. Are your needs the same as a 55 year old who began saving for retirement last year? I don’t think so. You have the freedom to take very little risk in your investments if that is what you choose to do. The new saver must take considerable risk to have any chance of building enough money for retirement. Yet, your employer and retirement plan steer you to the same fund. Remember, one size fits all.
The second problem is also a one size fits all problem, but a different version. This one assumes that returns and risks in investments are all the same. So, you make decisions based on years to retirement rather than market conditions. There are some Target Date Funds that consider both variables (they are called tactical or active Target Date Funds) and many that only consider years to retirement (passive Target Date Funds). You will have to look under the hood to understand which approach your TDF (Target Date Fund) takes. This may be difficult, but begin by looking through the Fund prospectus.
The adoption of TDFs is huge and growing quickly. A plan participant need only make one simple choice. The employer and plan provider reduce their risk as research shows that these funds work “on average”. So, they feel comfortable that they are unlikely to be sued by employees.
If you really think about it, TDFs are the silliest form of market timers that we have heard of. Market timers make changes in your portfolio as a result of their prediction of future market directions. These TDFs make changes in your portfolio based on the date (e.g. two years to retirement, time to sell some stocks). Portfolio changes should be based on the expected returns of investments and the risks that you need to take to achieve your financial goals.
You are one person with a unique experience (what years you are in the market, what savings you have, etc.). Being on a “glide path” with millions of other may not be the way to get to your destination in life.
By Ted Schwartz, CFP®