Target-date funds can be a great option for many investors who simply don’t have the time to manage their retirement portfolio. All you have to do is choose the year you plan to retire and the fund manager will worry about asset allocation. As you get older, the portfolio will shift more assets from stocks to bonds, theoretically resulting in a less volatile portfolio.
Target date funds can provide excellent portfolio management and provide an appropriate risk profile until retirement. But once you retire, they may fall short by allocating too much of the portfolio to bonds.
A look at the fund’s glide path on the target date
Changes in the asset allocation of a portfolio over time is called a sliding track. A target-date fund follows a defined path, which is usually set out in its prospectus or on the fund company’s website.
For example, Vanguard’s target date funds invest 90% in stocks and 10% in bonds for up to 25 years after your target retirement date. Then slowly increase your bond allocation each year until you reach 50% bonds and 50% stocks by retirement. It continues to increase its exposure to bonds over the next seven years until it reaches 70% bonds and 30% stocks, where it remains for the rest of the fund’s life.
While there is no standard glide path for target date funds, most follow a very similar trajectory. Automatic target date rebalancing can benefit many investors who don’t have the time, energy or interest to engage in any amount of portfolio management. However, there are some important drawbacks to consider.
Target date funds are unaware of your other assets
When planning for retirement, it’s important to consider all of your assets and how you can use them to finance your expenses. One of the biggest assets you’ll have in retirement is your Social Security.
The average monthly Social Security check is $1,669.44. The average person is expected to receive benefits for 19 1/2 years, given a life expectancy of 65 and the average age people start receiving benefits. This puts the present value of the average Social Security income at about $295,000 at a 3% discount rate. (Remember that Social Security is adjusted for inflation each year, so the discount rate can be generous.) If you can expect to live longer or earn more than the average salary during your working career, your Social Security will be worth even more.
Social Security should be treated as a fixed income asset. If your $500,000 portfolio is already 50% fixed income assets by the time you retire at age 65, your actual asset allocation could be more than two-thirds fixed income before taking Social Security into account. And by age 72, when the portfolio reaches 70% fixed income, it could be closer to 80% with Social Security.
That’s not to mention other assets that retirees may have, which could include another pension, real estate, or a portfolio of securities outside of their retirement accounts. If these are not taken into account, the asset allocation provided by the target date fund may not be suitable for the retiree.
Holding the majority of assets in fixed income instruments is not optimal
Virtually all funds to date adhere to the principle that bonds and other fixed income assets should make up the majority of your retirement portfolio. In fact, research shows that the optimal asset allocation is to use a V-shaped glide path where the bond allocation peaks at retirement age. In the first 15 years after retirement, the portfolio steadily returns to a majority stock portfolio before reaching a steady state.
The reason this works is that the return risk sequence is highest in the first decade or so of retirement. And not to be morbid, but there is also a reduction in terms for withdrawing funds. The use of a V-shaped slideway provides greater value to the terminal portfolio while reducing the sequence of return risks.
Most target-date funds continue to increase their exposure to bonds throughout retirement. And this is already problematic due to the fact that social security and other assets are not taken into account. But when you add the fact that it already puts retirees in an overly conservative financial position, it’s extremely suboptimal.
After you retire, you may have more time and energy to focus on your portfolio. Perhaps you should step away from the funds you invested in during your career and take a closer look at your financial picture to maximize your wealth and fund a great retirement.
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