Are target date funds good?
Target date funds are a commonly found option in employer sponsored plans such as 401ks. However, despite their popularity, with $3 trillion invested in these funds and counting, we feel that target date funds are not a good thing for investors.
Here is how they work – an investor picks a “target date” within a 5 year range when they’re likely to retire. Choices today range from 2025 to 2070. The closer the target date, the more fixed income (bonds) the fund will own. Conversely, anyone choosing the longest, 2070 date option will be invested primarily in equities (stocks). As you grow older, target date funds automatically increase the percentage of your money held in fixed income as you approach retirement.
Why have investors committed over $3 trillion to these funds? They are being offered as an easy, simple, one-decision solution to employer sponsored plan participants who feel they don’t have the knowledge to make asset allocation decisions with their contributions. And they follow an investing maxim that has been around forever – own less and less stocks as you approach and enter retirement to reduce your “risk.”
The definition of “risk” when it comes to investing your hard earned money generally means “losing money.” A corollary to that implies that the inherent volatility associated with investing in stocks is untenable for a retiree and should be avoided or at least minimized.
But history tells a different story. If you allow yourself enough time for an investment in a diversified basket of stocks, the risk of every losing money diminishes. In fact, there has not been any rolling 15-year period since 1950 when stocks have provided a total return less than bonds (source: J.P. Morgan Quarterly Guide to Markets, January 2022). Demographics tell us that the average couple retiring today will see at least one of them live at least three decades from their retirement date.
The word “inflation” has returned to our daily lives with a vengeance these last several months, but go back a few decades and it was the primary reason for concern among investors. In its simplest form, inflation means the price of goods and services that we all consume in our daily lives rises over time. And inflation most assuredly does not stop the day someone retires. In fact, inflation can have a greater impact on retirees due to their reliance on health care. Avoiding or minimizing exposure to the best inflation hedge available – stocks – in retirement as target date funds do is a recipe for eroding your purchasing power as you age, potentially having disastrous implications for those in their 80s and 90s.
It gets better (or worse if you’re a target date fund investor) – the so-called “safe” asset class known as bonds are particularly vulnerable in today’s economic climate. As interest rates have been close to zero for the last 15 years, bond prices have moved higher providing a nice return from a less volatile investment choice. However, we are poised to enter a tightening cycle by the Federal Reserve where as many as 5 interest rate hikes are expected in 2022 alone. The Fed, in their January meeting, hinted at rate increases starting in March. You are probably not going to see interest rates decline for the foreseeable future, ending a spectacular 40 year “bull market” in bonds.
We believe that choosing an investment that gradually increases bond exposure will be harmful to investors going forward. It is a classic example of “investing by looking in the rear view mirror.” An increase in bond holdings for the retired could not come at a worse time. Higher rates lead to lower bond prices, as rates and prices are inversely correlated. It is precisely the wrong time to be buying bonds. And many of the bonds held in target date funds are of higher “duration,” with longer term maturities, making them especially sensitive to interest rate changes.
It has been our conviction, and one to which we have held steadfast, that high quality equities are a better choice than fixed income, even for those in or nearing retirement. Inflation will always be with us, and the best way to combat that is by owning equities. We’ve articulated our investment thesis to clients in our allocation discussions, Investment Policy Statements, and in periodic reviews. If you wish to discuss this or any other aspects of your plan or portfolio, please let us know.
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