Target Date Funds Fail Retirees

Summary:

Target Date Funds are quite popular within 401ks. The purpose and strategy of these funds makes a lot of sense. However, for people that are close to retirement, these Target Date Funds may be missing the mark.

In this show we discuss how these funds may not be designed for those within 10 years, 5 years, or even closer to retirement.

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Podcast Transcript

Daniel Wendol
Target Date Funds are quite popular. It is becoming rare for me to see a new client without a target date option in their 401 K. The idea and purpose of target date funds make sense, however, when it comes to those close to retirement, these target date funds may be failing. In this show, we will discuss target date funds and specifically how they may not make sense for those within five years, 10 years or especially even closer to retirement.

Hello and welcome to another Dolphin Financial Radio show with me Dan Wendol, owner of the Dolphin Financial Group here in sunny Clearwater alongside me is Tony Shore. Actually he’s in his home. We are doing this remotely still as we are still undergoing the lockdown associated with Coronavirus. But today, Tony, we’re not going to talk about that. We’re going to talk about target date funds. Wake up, wake up.

Tony Shore
Wait, wait. We’re not going to…you lost me there. We’re not gonna talk about the corona virus? I thought that’s all every anyone could talk about right now. But this is good. So now you said target date. When you told me earlier, you sent me a message saying hey, Tony on the show this week, I want to talk about target date. And I’m like target date funds” And when I think of target date, I think okay, that’s when my wife and I meet up at Target, and kind of have a shopping date.

Daniel Wendol
Wouldn’t it be the Super Target that’s got the like food as well?

Tony Shore
Super Target date? A target date, that’s when you meet your girlfriend at Target. I don’t get it. So you’re gonna have to explain that to me how this all works.

Daniel Wendol
If I think if we focused on not going to arget and spending money that would probably save a lot more retirement funds then actually talking about target date funds! A target date fund is a mutual fund that’s in a 401k plan. When people look at their 401 K’s they have limited options. You know, here’s what the company is allowing me to buy. There’s a group of funds called target date funds that you can actually purchase in your 401k. And that’s what we’re talking about.

Tony Shore
What is a target date? Is it our funds with a specific date when they kick in?

Daniel Wendol
So it’s a lifestyle or lifecycle funds or a situational fund or mostly it’s built on your age. For instance, you might have a target date 2020, target date 2025, and a target date 2024. It is based on the year you expect to retire.

Tony Shore
Oh, yeah, we have used we have, right yeah, my wife and I our target date in her 401k and Ira, I think is for her, it’s 67 or 77. I think it might be, it might be 70 for her and 67 for me.

Daniel Wendol
Alright, so that’s the age at which you are planning to retire. So you buy a target date fund, which is designed to be held based on you retiring at that point. The idea is you buy this fund and it’s going to rebalance or adjust or reallocate your stock bond cash mix within the fund over time to kind of match your life cycle of when you’re going to retire. So in theory, as you get older and closer to the target date, the amount of stocks will go down and the bonds will go up in a very simplistic form.

Tony Shore
And a lot of people out there like, Hey, I don’t do I really need to worry about that. Well, it’s I think it’s probably an important thing to have. But that’s what you do. That’s what your you help your clients do is figure all that out. Right.

Daniel Wendol
Right. And I want to talk about specifically those that are getting close to retirement and how these funds might not be doing the job that they think they should be doing.

Tony Shore
Oh, really?

Daniel Wendol
Yeah. So target date funds have different investment styles as well. You might have active versus passive, but for the most part, they’re really designed based on the age you’re going to retire like we said. So you might say 2040 is when I’m going to retire. So I’ll buy the 2040 fund. And it’s simple. You just buy the fund. They’re prevalent. I mean, almost all of the people that I talked to now have an option of a target date fund in their 401k because they’re easy. And the main benefit of these funds is it prevents you from making stupid mistakes. For instance, when when the market drops 30% due to the Coronavirus, you’re not saying Hmm, maybe I should reallocate. The idea is you don’t do anything, you let the target date fund do the work. That’s why they’re so popular because they’re easy. The problem I see – a lot of people buy a 2025 fund and then they’ll put 30% in the 2040 fund also. That’s not how you’re supposed to do it. If you have a target a fund, you picked the target date and you put 100% of your 401k in it. And then you just set it and forget it.

Tony Shore
That’s that set it and forget it. Right, right. So you’re saying that’s not always a good thing, though?

Daniel Wendol
So here’s my big problem with it. And this is with most people’s 401 K’s but in particular the target date fund, there’s a false sense of security that I bought the 2040 funds, so I don’t have to revisit this, or think about it until 2040 when I go to retire. The problem with it is that the overall risk tolerance, the overall allocation as you get close to retirement, which is known as a glide path, if you think like you’re in an airplane, and you’re gliding, you lost power, but you have enough wind power to kind of float down to the ground – The glide path to retirement is when you touch the ground. The glide path in a target date fund may not match up with the most ideal or perfect glide path for you because everyone’s different. For instance, Tony, let’s say you were going to retire in five years. And you bought the 2025 target date fund. Okay. Is that appropriate? What amount of stocks versus bonds should be in the 2025 fund? What if you’re retiring in three years or one year? What is the ideal amount of allocation in those target date funds? We don’t know. Because your situation, even though you’re retiring in 2025, might be very different from someone else who’s also retiring in 2025. So these funds, however, are generic they have to be because they’re the same for everyone that buys it. So there’s a bit of a downside here as you get closer to retirement.

Tony Shore
Oh, okay.

Daniel Wendol
Because they don’t take in everyone’s unique situation.

Tony Shore
They are cookie cutter. What you’re saying is the problem with these target date funds is it’s kind of a cookie cutter and everybody’s personal situation is different.

Daniel Wendol
Yes, and the good part about the cookie cutter is that it’s simple, and everyone can do it. The bad part is, as you get close to retirement, you can’t use a cookie cutter. Most people can’t. It doesn’t make sense. My investment philosophy is this- As you get nearer to retirement, you need to reduce your risk exposure. But once you retire, you need to increase your risk exposure. So it’s kind of like, again, that plane landing- As you get close to the ground, you need to have less risk, but once you touch the ground, and want you to start bouncing back up again, and going back up in the sky with risk. So I have a little bit of a different take on what an appropriate amount of risk is for people. I always focus on income when you’re close to retirement. A general take for me is that 20-25% of your assets should be at risk when you go to actually retire, which could be very different than what these target date funds actually have for risk.

Tony Shore
So you’re saying that instead of using target date funds, and I think I’ve heard you’d say this before, and even rather than using a work related 401k, except for the match, of course, it’s better to have something you have more control over like an IRA with actively managed funds.

Daniel Wendol
However, at the same time at the other side of my mouth, I like the idea of saying you don’t have a lot of control because that prevents you from making silly mistakes.

Tony Shore
Well, it depends on whether you’re working with somebody like yourself a trusted financial professional, who works with a bunch of different independent funds so you can look at all the different options and investment companies and firms and stocks versus an actively Manage Accounts. Or versus somebody who, you know, if they’re going to try to do something on their own or work with a broker that might not have their best interests in mind, in probably in the long run might be just as good that they just have that cookie cutter to use. So they don’t make mistakes.

Daniel Wendol
Right. And I think as you get closer to retirement, then you have to really double check this because the target date fund might make sense for someone 20 years out, because there’s really not too much going on there. But if you’re within 10 years, five years, especially if you’re going to retire in the next year, you really need to reassess whether or not the target date fund makes sense for you. And I’ll show you why Tony. Target date funds are everywhere. I saw a 2018 report by Fidelity that 68% of millennials have 100% of their assets in a target date fund.

Tony Shore
Well, sure. But that makes sense to me. Yeah. If you’re gonna put money in a fund 401k and you’re gonna get a target date fund to put it all on the same fund. Don’t try and overthink it because you’re gonna mess up the diversity of it if you if you spreading it out trying to beat the system. So you’re not Warren Buffett.

Daniel Wendol
Right. There are three big target date fund companies. You got Vanguard, Fidelity and T. Rowe Price. They make up probably two thirds of the market of target date funds, those three companies

Tony Shore
Is TD Ameritrade one or is that something different?

Daniel Wendol
No, TD Ameritrade is a custodian so they hold money. TD Ameritrade may have a target date fund as well, but they’re not as popular as Vanguard, Fidelity and T Rowe Price. Let’s say Vanguard, they have money managers that actually build these target date funds and they say anybody that buys a 2025 fund is going to get this mix of stocks, bonds, international bonds, US bonds, US stocks, international stocks and so forth. So they design these things and they throw it out there to all the companies and the employees say yeah, we’re gonna buy Vanguards target date fund and throw it in the mix. So that’s going to be what my employees can buy. You could be in different industries, you could be in different parts of the country, but you’re all getting the same target date mix, if you buy that particular branded fund. I’m not going to pick on a company, I’m actually going to look at a company’s actual target date funds. I’m not going to tell you which one it is. But let’s look at a 2020 fund from one of these popular companies. The 2020 fund would mean when are you retiring Tony? When when does the 2020 fund mean you’re retiring?

Tony Shore
In 2020?

Daniel Wendol
Exactly. So this year. Coronavirus be damned.

Tony Shore
We did a show on somebody retiring this year. Last week or the week before. We’ve talked about toilet paper and a lot of other fun and exciting things. People should go back and listen.

Daniel Wendol
So the 2020 target date fund. All right, so you own that? I know, I’m throwing you under the bus here, but Tony, what percentage of it is in stocks to bonds in a 2020 target date fund? What percentage would be in stocks? And what percentage would be in bonds?

Tony Shore
I would say 80% in bonds, or 90% and 20% or 10% in stocks? And the theory is that because you’re so close to retirement, that you should have bonds which are less risky right?

Daniel Wendol
What if I told you that the popular target date fund 2020 is 50/50. 50% stocks and 50% bonds.

Tony Shore
I wouldn’t be surprised since that’s the popular one. I was just saying what I think I would do. I mean, I know from you telling me that people you meet with for retirement planning, when they meet with you and want to retire in three years, they have 100% in stocks.

Daniel Wendol
Yes, yes exactly. Even bonds can be risky.

Tony Shore
Sure, there’s risk with bonds. We saw that recently. Usually, when the stock market tanks like it did in March, you know, what? 30%. Right? Then bonds are stronger, but bonds went down too. And even gold wasn’t going up that much. So even the safe quote unquote, safe option of bonds, there’s still risk.

Daniel Wendol
Right, right. Exactly. And so I’ll get to that in a minute. But if you’re just looking at the target date funds, that surprises a lot of people. Wait, I’m retiring this year and half my money is still in the market!? And that might seem like a crazy thing, but in the long run, it’s good. Like I said, as you get older and into retirement, you should get a bigger percentage in the stock market, believe it or not, that’s the glide path I was talking about. But when you go to actually retire…due to sequence risk, due to unknowns of what it’s like to retire, I think a 20% allocation towards stocks is more likely going to be a better option for many people. Now, everyone’s different, of course, but this idea of 50/50 seems a bit too aggressive for me. If it’s taken in a silo if I’m just looking as your only money is your 401k, 50/50 at your retirement date seems a little aggressive. You look at the 2025 fund. So you got five years to retire. It’s 60/40 stocks/bonds. 2030- that means you have 10 years 68% stocks, 32% bonds. Seems like you have too much in bonds at that point. How about the 20 years? You have 20 years before you are retired. 2040 is your retirement date? 83% stock 17% bonds? Why do we have 17%? bonds? I’m not going to retire for 20 years. Does that make sense? So these general rules of thumb, I don’t like it. Do I need 17% in bonds when I have cash in the bank for an emergency fund? Maybe that can be my low risk money and 100% of my at risk money should be in stocks. You know, I think that the target date funds are great. They’re simple, and people should use them, because they don’t have the time. They don’t have the expertise to actually figure this stuff out on their own. But once you start really digging in and looking at the big picture, which is what I want to do right now is take take a step back and say, I’m not picking on target date funds. I think they have a purpose, but if you look at it in the big picture, this is where they fail. Let’s zoom out. Okay, the 2020 target date fund is 50/50 stocks to bonds. That seems like it’s in an inappropriate amount when I’m telling you 20% should be in stocks. What about your other assets? What about your cash in the bank? Savings? What if you have CDs or a pension? What if you have Home Equity? When you start taking all of your assets that you have outside of the target date fund, you put it on the table, and then you look at the pie chart and say, which of this is at risk? How much is that stocks? What you might find is that the 2020 target date fund, which has half of your money in stocks, that half in stocks, in the grand scheme of things of your overall portfolio is actually only 30% in stocks, because it didn’t account for the fact that you have cash over here and money in the CDs. So maybe you’re in good shape. But the problem is the target date fund managers don’t know that. And people that are investing aren’t really thinking that way. They’re only focused on that one small piece. That target date fund. So if the target date fund was the only money you had, then yeah, I don’t like the allocation. But if you have other money outside, maybe the allocation is appropriate. This all assumes that you have a big picture approach, which most people do not.

Tony Shore
Yeah. And plus, you know, when you’re you’re throwing out numbers, there’s also another aspect of, you know, what percentage should be in stocks, what percentage should be in bonds, there also should be a percentage, and I know this is assumed, but I think it’s good to remind people you shouldn’t have 100% in stocks and bonds. You should have some of your money elsewhere. We’re not talking about having all your money in stocks and bonds at every age, but as you get older, sometimes that money should be in other things as well. Probably in savings, emergency fund, CDs, some liquid stuff right?

Daniel Wendol
Exactly. You’re exactly right. That’s my point. That’s what I’m getting at. Thank you. The target date fund is 100% invested in risk assets. Well, actually, the 2020 fund has 8% in treasuries, which are fixed. So that I don’t mind at all. But you have to take a step back include the money in your home. You have to include your savings and checking account. You have to include the CD or the fixed annuity or the index annuity. Whatever you have outside the 401k, should be included in the big picture. And then once you take the big picture approach, maybe the target date fund works. But the problem I have with target date funds is that people don’t realize there there’s still a significant amount at risk with a target date fund even with being really close to that fund end date.

Tony Shore
Yeah, you have to ask yourself, How much am I willing to lose at that point? And is it right for where I am. For my age. For how much money I have. If somebody has a lot of money in savings or liquid or a huge pension, you know, that changes this whole story. But target date funds, most people have them, like you say. Most people don’t realize they’re paying fees in those 401k’s and those target date funds. And so there’s fees they might not know about a lot of people don’t even realize it. Is it properly allocated? And I think the answer to all this is to meet with a fiduciary, an independent financial adviser. And of course I know people are thinking Oh, yeah, you’re saying that because that’s what you do. But it’s true. Even if it’s not you they need someone they can trust but they should give you a call because you can look at that form and you don’t charge anything to look at it. Do you?

Daniel Wendol
No. In fact, that’s the idea. You could talk to the fund manager, but they’re not going to give you any answers because they have to do the cookie cutter approach. But the idea is to meet with someone to take the big picture approach and say, okay, you have this money in your 401k, the target date fund, here’s how much of that is in stocks and bonds, what about your other money, let’s combine it in a big picture. That’s what you need. As you get closer to retirement, it’s even more critical. Because there are some other things like you just mentioned, if you have a pension, if you have an income stream already planned out, social security is a good example, if you have the income you need to live, my philosophy is once you have that income set, you can take on more risk, which is counterintuitive. So that’s why someone that has 100% of their money in the 401k in stocks at age 65 and they’re retiring next year may actually be appropriate. If I’ve done the math and said you know what, let’s Go for it. Because you have your Social Security, you have your pension, you have this annuity over here giving you a guaranteed income, you don’t need any more income, we can let this money ride. We can let the stocks ride so that in the long run, 20 years from now, when you might need that extra money, it’s going to be there because the stock market is the place to be. So you’re right, you have to meet with someone and look at the big picture. You can’t just go in the silo. And you can’t just let this target date fund ride it out without stopping and looking at the big picture. I strongly believe that those closer to retirement should meet with someone outside of their 401k to get that snapshot and get that opinion. That doesn’t mean they have to sell the target date fund. That doesn’t mean they have to roll their 401k out of their employer plan. It just means that they should meet with someone that’s willing to look at it and give them an opinion without requiring that they move all the money under them. You know what I’m saying? I have clients that I work with that still own target date funds in their 401k. That doesn’t mean I won’t work with them because they have a 401k. I don’t charge fees on this, but I still give them guidance and opinions on it, because that’s what they need. That’s what makes sense for them.

Tony Shore
Yeah, that makes perfect sense. And so obviously, this is a no brainer. If you’re listening out there, you need to pick up the phone set up that complimentary no cost, no obligation, strategy session or consultation to look at where you’re at, right?

Daniel Wendol
Yeah, you don’t bury your head in the sand. The idea of a target date fund is so you bury your head in the sand. You buy it, you set it, you forget it. I love that. But as you’re getting closer to retirement, you’re within 10 years, you have to take your head out of the sand and reassess. Maybe you’ll put it right back in the sand. I’ll talk you through it. It’s not an overly complex discussion. It is a just a gut check. It’s a retirement reality check. We’re going to look at the big picture for you and say, Does this make sense? And maybe you’ll just leave it or maybe we’ll make tweaks. I don’t know it all. It depends on everyone’s individual situation, which is why I like the idea of a target date fund in the grand scheme of things. It makes things simple. But I don’t like it because it’s too cookie cutter for me, especially as you get older closer to retirement.

Tony Shore
Right. Well, you know what a good show today, I learned a lot about target date funds, the good and the bad. And I think that was your purpose.

Thanks for listening to Dolphin Financial Radio based in the Clearwater, Tampa area.