On paper, it seems easy enough. You pick the target-date fund that best matches your anticipated year of retirement and then you sit back and watch your account balance grow till you call it quits.
The problem, however, is this: You’re underestimating by 4.8 years how long you’ll be in the workforce and, as a result, you’re investing in the wrong target-date fund.
And it’s costing you money, according to a new research report, Missing the Target? Retirement Expectations and target-date funds.
How much is it costing you? On average it’s 4% or 0.2% a year, according to the authors of the paper, Byeong-Je An, an assistant professor of finance at the Nanyang Business School at Nanyang Technological University and Kunal Sachdeva, and an assistant professor of finance with the Jesse H. Jones Graduate School of Business at Rice University.
So, what might you do, given An and Sachdeva’s research?
The obvious answer is this: Instead of investing in the target-date fund that you think best matches your anticipated year of retirement, consider investing instead in the one five years after your anticipated year of retirement. For instance, invest in the 2035 fund instead of the 2030 fund or the 2050 fund instead of the 2045 fund.
By doing this, you’ll avoid having a shortfall in future wealth.
But does this make sense to those who eat, breathe and sleep all things target-date funds?
Not so much.
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If it ain’t broke
“I think that target-date funds, along with automatic enrollment, have been two of the most positive retirement plan innovations of the last decade,” said Mike Webb, a senior financial adviser with Captrust. “Thus, I am always a bit suspicious of anything that tampers with their basic fundamentals, such as changing the target date to one that is well, not actually the target.”
In most plans moving five years beyond the participant’s actual retirement will increase one’s equity position at all ages, in the case of a through-retirement fund, and at all preretirement ages, in the case of a to-retirement fund, said Webb.
“Since those who create glide paths do give a lot of thought to the subject, and those paths have worked historically even through volatile markets; I would adhere to the mantra ‘if it ain’t broke don’t fix it’ with respect to such a time horizon change,” he said.
It might not be broken, but one’s target-date fund might need a check in, said Jack Towarnicky, an employee benefits expert who is of counsel at Koehler Fitzgerald.
“Many target-date funds maintain equity allocations in excess of 50% through the target date and beyond,” he said. “So, while the (researchers don’t) offer a solution, one practical option would encourage workers to perennially check on the underlying investment allocations, update their anticipated benefit commencement date — not their employment end date — and adjust as necessary.”
Automatically defaulted into an age-appropriate target-date fund
Of course, many plan participants aren’t even thinking about their anticipated year of retirement when selecting a target-date fund. In fact, most, about two-thirds, are defaulted into a target-date fund according to the Plan Sponsor Council of America. “Many, perhaps most target-date fund investors, were defaulted as part of automatic enrollment,” said Towarnicky.
And that’s not a bad thing. The majority of 401(k) participants investing in one target-date fund held a fund appropriate to their age, which according to the Investment Company Institute (ICI) is the target date closest to the year that the plan participant turns 65. “Most people don’t actually estimate their date employment will end,” said Towarnicky. “Most readily accept the traditional age 65, even though Social Security’s full retirement age changed in 1983.”
The ICI noted that individual investors may:
- have a different target retirement age in mind (e.g., age 67 for Social Security full retirement age; or age 55 for police/fire),
- be seeking more focus on growth (choosing a later target date than their age suggests, making them old for the fund)
- be seeking more focus on income (choosing an earlier target date than their age suggests, making them young for the fund).
Plans don’t always work out
There’s another factor to consider, as well. Some workers might pick a target date based on their anticipated year of retirement. But reality may get in the way of a participant’s best-laid plans. “Participant estimates of the end of employment would not include involuntary dislocation due to health or organization change,” said Towarnicky, who noted that annual studies by the Employee Benefit Research Institute consistently show many retired prior to their expected date.
What to do then?
Target-date funds are generally considered set ‘em and forget ‘em funds. But it would be a mistake to do that. A periodic review, as Towarnicky suggested, would be prudent.
Among other things, ask:
- Is the fund’s asset allocation in line with your risk tolerance and other assets?
- Does the target date match your anticipated year of retirement or the year you expect to start withdrawing money from your account?
- Do you own a to-retirement target-date fund or a through-retirement target-date fund? There’s a big difference. According to Finra, “a ‘to-retirement’ target-date fund will reach its most conservative asset allocation on the date of the fund’s name. After that date, the allocation of the fund typically does not change throughout retirement. A target-date fund designed to take an investor ‘through retirement’ continues to rebalance and generally will reach its most conservative asset allocation after the target date. While these funds continue to decrease exposure to equities throughout retirement, they may not reach their most conservative point until the investor is well past age 65.”
And, as you get closer to your anticipated year of retirement and the year you expect to begin withdrawing money from your fund, maybe consider different investment options and, perhaps, an investment adviser. A target-date fund might work well while you’re young and your financial matters are uncomplicated. But such funds work less well when you’re older and your finances become more complicated.