Target date funds can be a great option for many investors who simply don’t have the time to manage their retirement portfolios. All you have to do is select a year in which you plan to retire and the fund manager will take care of the asset allocation. As you get older, the portfolio will shift more assets from stocks to bonds, theoretically leading to a less volatile portfolio.
Targeted funds can do a great job of managing a portfolio and ensuring that the risk profile is appropriate before retirement. But once you retire, they can fall short by allocating too much of your portfolio to bonds.
A look at a fund’s descent path with a target date
Changes in asset allocation over time in a portfolio are called glide paths. A target data fund follows a specific descent path, which is usually displayed in its prospectus or on the fund company’s website.
People are also reading …
For example, Vanguard’s target date funds invest 90% in stocks and 10% in bonds up to 25 years from the target retirement date. Then slowly increase the bond allocation each year until it reaches 50% bonds and 50% stocks by retirement. Continue to increase exposure to bonds over the next seven years to reach 70% bonds and 30% equities, which is where it stays for the rest of the fund’s life.
While there is no standard flow path for date-targeted funds, most follow a very similar trajectory. Automatic rebalancing for date-targeted funds 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 major drawbacks to consider.
The target date funds don’t know your other assets
When planning your retirement, it is important to consider all of your assets and how you might use them to finance your expenses. One of the biggest assets you will have in retirement are your Social Security benefits.
The average monthly social allowance is $ 1,669.44. The average person is expected to collect their benefits for 19 and a half years based on their life expectancy at 65, and the average-aged people start collecting benefits. This makes the present value of the average Social Security benefit equal to approximately $ 295,000 at a discount rate of 3%. (Remember, Social Security is adjusted for inflation each year, so the discount rate can be generous.) If you can expect to live longer or earn an above-average salary during your career, your benefits of social security will be worth even more.
Social security should be considered a fixed income activity. If your $ 500,000 portfolio is already 50% fixed income when you retire at age 65, your actual asset allocation could be more than two-thirds of fixed income when accounting for Social Security. And by 72, when the portfolio reaches 70% fixed income, it could be closer to 80% when social security is taken into account.
Not to mention other assets that retirees may hold, which could include another pension, property, or portfolio of securities outside of their retirement accounts. If these are not taken into account, the asset allocation provided by a target data fund may not be appropriate for a retiree.
Maintaining most fixed income assets is not optimal
Virtually all target date funds follow the principle that bonds and other fixed income assets should make up the bulk of your retirement portfolio. Indeed, research shows that optimal asset allocation is to use a V-shaped glide path where bond allocation peaks at retirement age. The portfolio steadily reverts to a majority stock portfolio in the first 15 years of retirement before reaching steady state.
The reason it works is because the return risk sequence is highest in the first decade or so of retirement. And, not to be morbid, but there is also a shortened timeline for withdrawals. Using the V-shaped glide path provides greater terminal portfolio value by mitigating the risk-to-return sequence.
Most target date funds continue to increase exposure to bonds during 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’s already putting retirees in too conservative financial position, it’s extremely suboptimal.
Once you retire, you may have more time and energy to pay attention to your wallet. It may be appropriate for you to abandon funds for the target date you invested in during your career and take a closer look at your financial picture to maximize your wealth and fund a great retirement.
The $ 18,984 Social Security Bonus that most retirees completely overlook
If you’re like most Americans, you’re a few years (or more) behind on your retirement savings. But a handful of little-known “social security secrets” could help ensure a rise in your retirement income. For example: a simple trick could make you pay up to $ 18,984 more … every year! Once you learn how to maximize your Social Security benefits, we think you could safely retire with the peace of mind we all seek. Just click here to find out how to learn more about these strategies.
The Motley Fool has a disclosure policy.