Target Date Doubts

Sometimes the smartest people do perplexing things. We’re all too familiar with stories of retirement plan participants making poor investment decisions. But we were surprised when a colleague’s spouse – a globe-trotting consultant with a Ph.D. in a quantitative field, no less – confessed to a basic investment mistake. He keeps much of his retirement plan assets in an appropriate target date fund, but spreads the rest of it around among other investment options. “At some level I know that’s wrong,” he explains, “but I just don’t trust target date funds to deliver the results I want.”

Perhaps it’s a case of a little knowledge being more dangerous than none at all. Our industry has spent decades trying to convince Americans to be “active investors.” We’ve seen limited success, along with unintended consequences such as panic reactions when the markets spike. Realizing the limits of what’s possible we’ve also promoted all-in-one solutions. It’s no wonder some people are confused about what they’re supposed to do.

Missing Math
Accidentally unbalancing your diversification strategy by combining other significant retirement investments with a target date fund is just one risk of these investment vehicles. As we've discussed before, perhaps the most important is the fact that while retirement age is an important factor in retirement planning, savings rate and desired income replacement are equally critical. Any retirement math that doesn’t account for all these major variables can’t provide the most accurate result.

Accuracy is even more of an issue when people’s financial lives involve more than one individual and one plan, as most do. A managed account approach can consider other plans, non-plan assets, financial needs besides retirement, and the complexity of planning with a spouse. A target date fund is blind to this level of detail.

Hidden Risks
Looking ahead toward retirement, we see the glide path of many target date funds bottoming out on or near the chosen date. Given that a typical retiree may need a steady income for more than two decades, this is hardly the time to stop adjusting the asset mix (though to be fair, some funds continue to glide for many years after retirement). We caution GuidedChoice investors that the inflation risk of a too-conservative portfolio can actually be more dangerous than the risks of a more aggressive one, and we find it ironic that “safe” funds expose owners to the same hazard of low yields.

Target date funds can involve other risks as well. One observer points out that because bond funds weight their holdings by the size of the borrower, passive funds will automatically “have increasing exposures to those borrowers whose indebtedness is increasing and whose credit worthiness may be declining.” In other words, your retirement plan just doubled down on Greece. By definition passive funds offer no risk management, in an environment where inflation and default are very real concerns.

Dollars to Donuts?
So the perception that target date funds are less risky than a more active approach has some serious flaws. The perception that some are less costly has merit, at least on the surface. But even if the “sticker price” of a managed account may sometimes be more than for a target date fund, a long-term view of active management tells a different story. Schwab, for example, has found that plan participants who use our advice services tend to save twice as much, were better diversified, and stuck to their long-term plan, even in the most volatile market environments.

Given this kind of success, doesn’t it make sense to steer all participants into managed accounts? We think so. More importantly, so do our investors: in plans where our service is the default, we’ve seen nearly 90% stay with it rather than opting out to self-directed accounts.

The true value of anything isn’t what’s on the price tag. It’s in the results. For retirement investing we’d define that as the total retirement income delivered over the lifetime of the investor. By that standard personalized, professional advice is far and away the most cost-effective approach to retirement investing. We’re ready to argue the case in the court of industry opinion. And we think the 401(k) world is ready to hear it.