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Today, most 401(k) retirement plans offer a group of “target date funds.”
Wes Shannon
Generally they are 15, 20, 30, and even 40 years forward for the targets. Several plans now use a target date fund as the default alternative. If an employee does not select any investments in the plan, they are invested in a target date fund automatically. Unfortunately, target date funds are not generally the best option in a 401(k).
What exactly is a target date fund? It is typically a mutual fund that divides its investments into asset classes and then automatically shifts those investments from higher volatility assets to lower volatility assets as the fund approaches its stated target date — with the goal of having 100% of the assets in cash by the target date.
As an example: A target date fund of 2054 would start today with around 95% of the investments in stocks and 5% in cash and bonds. Every two years, it would shift some of the assets from stocks to bonds/cash so that 15 years out (2039), there might be closer to 50% in stocks and 50% in bonds and cash. By the target date (2054), it would be 5% or less in stocks and 95% or more in cash and short-term bonds.
The basic — and perhaps flawed — premise is that you want to be more aggressive (that is, hold more volatile investments) when you’re younger and more conservative (that is, hold less volatile investments) as you approach retirement. The fear of having accumulated a large amount of money and having the stock market crash 35% the year you plan to retire is one of the situations a target date fund tries to avoid.
A basic understanding of the stock market vs. the bond market is important when deciding if a target date fund is a good idea. Over a 30-year period, stock investments have historically averaged gains of around 10% per year. But that return varies widely within any individual year, with stock returns ranging anywhere from up 35% or more to down 35% or more. On the other hand, bonds historically average around 5%-6% over decades but may fluctuate up or down two to three times that in any individual year.
So, when you have 15 or more years between now and retirement, having your stocks drop 30% still gives you plenty of time to recover from that downturn. However, if your stocks drop 30% the year before retirement, you’re far less likely to recover in time, right? Maybe not.
This is where the philosophy of target date funds has some flaws. Basically, target date funds assume you will want all of your retirement money on the date of your actual retirement. This “target date assumption” can cost 2% or more on average for the entire run of the fund and could leave a person with 30% less at retirement. Why? Because almost all retirees draw their funds gradually over time.
If you contribute to a 401(k) and your employer matches your contributions for 30 years, you may have $2 million upon retirement, but you are not going to take the full $2 million and go to Vegas or put it in a safe at the house.
Most people spend about 4%-5% of what they have accumulated each year. So, if you have $2 million, you would probably only spend $80,000 to $100,000 in the first year and each year afterward. If you retire in your 60s you will still have 15-25 more years to invest until the end of life.
You actually do have time to recover from a loss at retirement.
If a person with $2 million the year before they retire sees their 401(k) drop to $1.6 million upon their retirement date, it’s OK. They only needed $80,000 the first year after retirement and can let the remaining $1.52 million stay invested and recover.
I’m not suggesting that a person stay 100% in stocks until or through retirement. But your investment portfolio doesn’t necessarily need to automatically become more conservative as you approach retirement. In fact, maintaining a consistent allocation (that is, a little more aggressive than the traditional target date fund) may produce a better result for your retirement.
That’s where the “target date assumption” and making the “easy” investment choice may lead you astray. Consider working with a Certified Financial Planner® who can help tailor your 401(k) investment selections to your specific needs.
Wes Shannon CFP® is a Certified Financial Planning Professional for Brazos Wealth Advisors.