The Truth About Target Date Funds

Hi. Matt Blocki with EWA. Jamison Smith with EWA. Today we are excited to talk about target date funds, and specifically, we’re excited to talk about why we believe they are not a fit inside of your investment portfolio and your financial plan.

The target date funds have become a default option for a lot of 401K providers. And one thing we will point out is this as option is much better than having your money sit in cash. But we believe that you can do much, much better by following specific principles of investing, such as asset allocation diversification, long term investing, et cetera.

Jameson and I today are going to go through in great detail why we specifically recommend against the target date funds and why. So, Jameson, give us a high level overview. First of, how does a target date fund work?

Sure. A target date fund essentially lines up your asset allocation with the target date of your retirement. So, example, if you’re in a target date fund for 2025, they say, we’re five years from retirement.

Let’s gradually scale back your equity to bond exposure as you get closer to the year 2025. Awesome. What are some of the main concerns that we have with target date funds? Yeah, so this is kind of a blanket recommendation that doesn’t take into consideration things like how much is Social Security paying you?

Do you have a pension? How much does your family need to live on in retirement? Is there any health concerns? Longevity? All of these things need to be considered when looking at your investment philosophy and asset allocation.

Excellent. So if I am a young, young individual, where in a target date fund, where does my stock to bond ratio start? And then typically, where does it end, assuming I retire at 65? Generally you’ll start between somewhere between 90, ten, or 100, and then it’ll gradually scale back.

When you get your retirement, you’ll end somewhere around a 60 40 or 50 50 portfolio. One of the problems, Jameson, that you’ve mentioned to me about a target date fund is the inability to do a strategic rebalance or a tactical move.

So, for example, in March of 2020 at Ewa, a lot of our clients, when the equity markets had gone down 34% in the matter of 23 days, a lot of the fixed income allocation we sold, which held its value very well.

We bought those equities at the 34% discount, and then within a couple of months, there’s a rebound, and that panned out very well for our clients. And portfolios that had the time horizon allowed that, how would we be able to do that with a target date fund?

Yeah. So this would be up to the mutual fund manager to do this. It’d be up to their discretion. If you’re in a properly asset allocated portfolio, you can pick and choose which asset class. Like Matt just said, you can sell the fixed income that’s high, buy stocks that are low.

With a target date fund, you don’t have that ability. The mutual fund manager, again, could do that, but you just have to sell across the board, sell a little bit out of every asset class rather than.

Picking which one interesting. So that is a huge problem. If someone in that example is trying to move selling high and buying low, that would be impossible because that manager is locked into the strategy that’s here’s a defined set of bonds and equities based upon your age, and then it’s pretty much a set it and forget it strategy moving forward.

Am I understanding that correct? Absolutely, yeah. Okay, so if I’m a retiree and I’m distributing money out, what problems do we foresee if I’m in a target date fund and using that target date fund for the distributions?

Sure. So always use financial planning, like climbing the mountain, and then you get into retirement, you have to go down. So distribution and being able to pick what asset classes as you come down that mountain can be crucial on your portfolio long term.

We’re going to go over a specific example in a second, but always want to make sure you have seven years backup of safe assets or bonds. As you enter retirement and then strategically choose selling those funds depending on what the market’s doing.

So obviously, sell equities when the market’s high, sell the bonds when the equities are low. So, Jameson, tell us, for someone that is in the distribution, you gave me the example of climbing the mountain, getting down.

For someone getting down from the mountain, what challenges does a target date fund provide? Yeah, so example, if we’re in a recession, 2008 is a good example. All equities were down, bonds are up maybe two or 3%.

We’re able to strategically pick to sell the bonds and let the not sell the equities at a loss. With a properly asset allocated portfolio, we can pick and choose which fund we want to sell, rather than just selling across the board like a target date fund.

Interesting. So in a target date fund because it’s one fund that holds maybe eight different asset classes. When you are distributing money on a monthly or annual basis, you’re actually selling out of eight asset classes, some at a gain.

Some at a loss, when in reality, the whole purpose of asset allocation is to be able to pick and choose. Just picking out the gainers and letting the losses recover. That’s the whole purpose of asset allocation.

So it completely defeats the purpose of a good defined distribution strategy. Well, James, I know you have a specific example for someone in distribution system that looks at the target date fund along with other income sources.

Why don’t you help us break this down? Okay, so this is a specific example. Of somebody approaching retirement. Let’s assume they’ve saved a total of. A million dollars in assets. And here’s the breakdown.

That have 750,000 in their employer 401K. They’ve assumed they’ve been at this job for a while. 500,000 of it is in the pretax. Four hundred and one K. And they’ve. Made some Roth contributions. So they have 250,000 in the Roth 401K.

Outside of the 401K, they have 150,000 in the pretax IRA. 100,000 just in a taxable investment account or brokerage account income needs, they’re getting ready to retire. They need 100,000 of income each year.

And we grow that with inflation as they go through retirement. So this couple, let’s say they get into retirement and they need 100,000 a year to live on, and we grow that by 3% each year for inflation.

So let’s assume they have Social Security. It’s paying them a total of 60,000. Maybe one spouse maxes out at 40,000, the other one’s claiming half of the benefit, so a total of 60,000. Social Security also grows with inflation.

So based on this example, the Social Security is coming in every month no matter what. So we just need to bridge this gap of 40,000 a year from the portfolio. If this client was in a target date fund, they get into retirement.

A 2025 target date fund. Let’s say they’re getting ready, they’re five years away. 2025 target date fund would be a 60 40 allocation. That would be 400,000 of bonds. Why we think that is inappropriate?

Our philosophy is we need seven years of income backup in safe assets like bonds. But we don’t need all, as you see, we don’t need the whole 100,000. We don’t need 700,000 in bonds because they already have 60,000 a year coming in.

So this gap of 40,000 needs to be in a seven year backup. They have a safe asset like bonds. So for this scenario, we need 40,000 a year times seven years in a safe asset like bonds. Cash value to life insurance policy.

Proper asset allocation would be 280,000 in bonds, which would be approximately a 70 30 allocation and the proper breakdown. This is a whole separate video of asset location. But the Preta Axe 401K, we’d recommend a 65 35 allocation, 175,000 of bonds.

The Roth 401K, any Roth accounts in the taxable account, we want all equities. So this will be 100% equity, 0% bonds. In the pretax IRA, we’d recommend a 30 to 70 allocation. So all of this looking at the whole financial plan, all of their accounts allows this client to be more aggressive than if they were just in a total target date fund.

So long term, this could have a huge impact on your portfolio. Many people are living 30 years in retirement, retire at 65, they’re living till 95. So they have to draw on these assets for a very long time.

So let’s assume a million dollars. We’re withdrawing 40,000 a year and a 60 40, let’s say it grows at 6% every year, which is not bad. In retirement, this client would get to age 95 with those withdrawals, and the total value of their portfolio would be two and a half million dollars.

So really, that’s awesome. They haven’t diminished their principal, but proper asset allocation could enhance this. So, same scenario, except we’re allocated in a 70 30 allocation. And let’s say the 70 30 averages just 1% difference because we have a 10% difference of equity exposure.

Now we’re averaging 7% a year rather than six. Same thing, pulling 40,000 a year. And the difference that makes the end value is 3.8 million. So just having the proper asset allocation investment strategy within retirement could be a difference of $1.3 million in this specific scenario.

So overall, target date funds can be a better scenario, like Matt said, than just having the money sitting cash. But overall, we’d want to take into consideration the entire financial plan and try to invest in low cost funds within your 401 rather than just a default target date fund.

Any specific questions? Feel free to reach out.