Vanguard’s “How America Saves 2018” study reveals that roughly 50 percent of defined contribution plan participants use a target-date fund (TDF) as their sole investment. By 2022, this figure is expected to grow to 70 percent. But should retirement savers be relying solely on these set-it-and-forget-it vehicles? Does that change depending on when they first started saving? And how effective are these funds at managing retirement savings risks, particular as investors approach this next life stage? As a financial advisor guiding investors to a comfortable retirement, it’s important that you can answer these questions. So, let’s take an in-depth look at TDFs.
TDFs are designed to simplify the investment process by allowing retirement plan participants to access a diversified mix of stocks, bonds, and other investments through a single vehicle. As retirement nears, TDFs work to mitigate risk by strategically adjusting asset allocations away from riskier investments (e.g., equities) to more conservative options (e.g., bonds). This hands-off approach can be appealing to investors uncomfortable with financial decision-making.
As you know, however, it’s difficult to apply a universal solution to a complex problem. For some investors—especially those close to retirement—TDFs may not be the ideal fit for managing retirement savings risk.
All investments carry some degree of market risk. During a stock market downturn, any fund heavily weighted toward equities has the potential for a substantial loss. Younger investors, whose TDFs will have greater equity exposure, are likely to experience a larger performance decline in percentage terms. But even investors closer to retirement may find their funds still maintain an equity allocation near 50 percent. Where younger individuals have time on their side, older investors may not be so lucky. In fact, studies show that the timing of market fluctuations can play a meaningful role in retirement outcomes.
Simply put, a market decline early in a career is more manageable than if it occurred closer to retirement. According to the Congressional Budget Office, more than $2 trillion was wiped from retirement accounts following the 2008 market crash—leaving many scrambling to pull themselves out of a savings pit. As investors approach middle age, it’s important to reassess their risk tolerance and ensure that they are comfortable with the risk level their TDF is exposing them to. Here, evaluating a fund’s general asset allocation is a good place to start.
Asset Allocation Risks
Consider an individual who has just reached middle age. She has been diligently contributing toward her 401(k) since her early 20s and has accumulated a sizeable balance invested in a single TDF. Historically, the fund has performed well, and it currently sits at an allocation of 60-percent equities to 40-percent fixed income. Our investor is comfortable with this risk-return profile. With 40 percent of the fund’s holdings allocated to bonds, she believes her savings will be shielded from a stock market downturn.
But then a recession hits. Soon, the stock market is down nearly 25 percent; as anticipated, the equity side of our investor’s TDF struggles. Luckily, the fixed income allocation is there to soften the blow, right? Unfortunately, as this individual assesses the damage, she realizes her investment has suffered a substantial loss and that the fixed income allocation didn’t protect her during the crash.
Upon even closer inspection, it becomes clear that the fixed income allotment was more heavily invested in high-yield bonds than anticipated. High-yield bonds, or “junk” bonds, are higher-risk investments that produce higher returns than safer options such as government bonds. High-yield bonds also tend to be more correlated with the overall market. At first glance, the fund in this scenario appeared to shift its risk profile in accordance with its glide path. Additional scrutiny revealed a different reality.
In 2017, The Lancet conducted a study that examined the populations of 35 developed countries. It found that life expectancy was projected to increase across every single one. Although this is encouraging news, there are negative consequences to consider—particularly outliving one’s savings. This makes it increasingly worthwhile for advisors to work with their clients to evaluate TDF glide paths to determine whether the funds are likely to help them reach their savings goals.
Older investors may realize their 401(k) balance won’t be sufficient to sustain them through retirement. A TDF whose glide path has already begun to shy away from stocks is unlikely to provide a return that adequately narrows that gap. If older clients are comfortable assuming more risk to produce higher returns, they may find greater benefit in a portfolio that is constructed with consideration given to their personal retirement timeline.
Save the Late Savers
On the other hand, having an account balance at all puts 401(k) participants ahead of the curve. According to a 2017 Government Accountability Office study, approximately half of all American households age 55 and older have no retirement savings. This is where TDFs can be a convenient—and diversified—solution. Is a TDF the right fit for those arriving late to the savings game? As the saying goes, “The best time to plant a tree was 20 years ago. The second-best time is now.”
When it comes to selecting a TDF, not all funds are created equal. In evaluating TDF glide paths, it’s important to determine whether the fund series adheres to a “to” or “through” strategy:
The “to” strategy
- Designed to bring investors to their predetermined retirement date, where no additional allocation adjustments are made
- More appropriate for investors comfortable sacrificing additional equity returns for the security of a more conservative portfolio
The “through” strategy
- Funds continue to reallocate into the investor’s retirement years
- More appropriate for investors expecting additional market returns to boost their retirement income
Understanding this distinction may help investors determine which funds most closely align with their intended outcome. Given that life spans continue to extend, one must consider whether TDFs are positioned to accommodate late savers.
Treat the Situation
For most investors, the ease and convenience of TDFs outweigh the drawbacks. Provided saving is done early and often, these funds remain a viable option for helping people reach their goals and managing retirement savings risks. Of course, every situation is unique. Taking the time to understand each client’s specific position and outlook will go a long way in getting them to where they want to be.
As you evaluate TDF glide paths for your clients, what risks have you uncovered? Has this affected your decision to recommend these savings vehicles? Please share your stories with us!