Target date funds can be a great hands-off 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 around when you expect 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 leading to a less volatile portfolio.
Target date funds can do a great job of managing a portfolio and ensuring the risk profile is appropriate leading up to retirement. But once you’re in retirement, they can fall short by allocating far too much of the portfolio to bonds.
A look at a target date fund glide path
The changes in asset allocation over time in a portfolio are called a glide path. A target date fund follows a specified glide path, which is usually laid out in its prospectus or the fund company’s website.
People are also reading…
For example, Vanguard’s target date funds invest 90% in equities and 10% in bonds until 25 years from the target retirement date. Then it slowly increases the allocation of bonds every year until it reaches 50% bonds and 50% equities by retirement. It continues to increase exposure to bonds over the next seven years until it reaches 70% bonds and 30% stocks, which is where it stays throughout the rest of the fund’s life.
While there’s no standard glide path for target date funds, most follow a very similar trajectory. The automatic rebalancing for target date 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 important drawbacks to consider.
Target date funds don’t know about your other assets
In retirement planning, it’s important to consider all of your assets and how you might use them to fund your spending. One of the biggest assets you’ll have in retirement are your Social Security benefits.
The average monthly Social Security check is $1,669.44. The average person is expected to collect their benefits for 19 and a half years based on life expectancy at 65 and the average age people start collecting benefits. That makes the present value of the average Social Security benefit equal to about $295,000 at a 3% discount rate. (Remember, Social Security is adjusted for inflation every year, so that discount rate may be generous.) If you can expect to live longer or earn a higher than average salary during your working career, your Social Security benefits will be worth even more.
Social Security ought to be considered a fixed income asset. If your portfolio of $500,000 is already 50% fixed income assets by the time you retire at 65, your actual asset allocation may be more than two-thirds fixed income when accounting for Social Security. And by 72, when the portfolio goes to 70% fixed income, it may be closer to 80% when accounting for Social Security.
That’s not to mention other assets retirees may hold, which could include another pension, real estate, or a portfolio of securities outside of their retirement accounts. If these aren’t taken into account, the asset allocation provided by a target date fund may not be appropriate for a retiree.
Keeping the majority of assets in fixed income isn’t optimal
Pretty much all target date funds follow the tenet that bonds and other fixed-income assets should make up the majority of your portfolio in retirement. In fact, research shows the optimal asset allocation is to use a V-shaped glide path where bond allocation peaks at retirement age. The portfolio steadily drifts back toward a majority securities portfolio in the first 15 years of retirement before reaching a steady state.
The reason this works is because the sequence of return risk is highest in the first decade or so of retirement. And, not to be morbid, but there’s also a shrinking timeline for withdrawals. Using the V-shaped glide path provides greater terminal portfolio value while mitigating the sequence of return risk.
Most target date funds continue to increase exposure to bonds throughout retirement. And that’s already problematic because of the fact that Social Security and other assets aren’t taken into account. But when you add in the fact that it’s already putting retirees into too conservative of a financial position, it’s extremely suboptimal.
Once you retire, you may have more time and energy to pay attention to your portfolio. It may behoove you to ditch the target date funds you invested in during your career and take a closer look at your financial picture in order to maximize your wealth and fund a great retirement.
The $18,984 Social Security bonus 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 boost in your retirement income. For example: one easy trick could pay you as much as $18,984 more… each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we’re all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.