A recent innovation in retirement investing is the target date fund. As financial innovations go, this one is better than most, but we have some reservations about it.
Target date funds were designed so investors could put their savings into one low-cost fund and forget about it until retirement as assets automatically adjust the allocation between stocks and bonds over time. You pick a fund with a “target date” around the time when you plan to retire. When you’re young it holds mostly stocks—usually passive funds that track the S&P 500 index—and as you get older it shifts into more conservative investments, usually bonds. These kind of funds now manage more than $550 billion according to Morningstar, up from only $160 billion in 2008.
A recent Wall Street Journal feature “Missing the Target”, however, warns that these funds are not as simple and appealing as they may seem. In fact, target date funds are far more complex and often more expensive–and therefore more risky–than most people realize. Anyone who owns these funds or is considering them should give the Journal article a careful read. We agree with the Journal’s skepticism. Apart from the lack of transparency and general confusion surrounding target funds that the Journal points out, we see three general flaws.
First of all, the the idea of a target date (and setting the target date at retirement) suggests a level of precision that is not possible in financial planning. The real target date is when you die and we know neither the day nor the hour. If you run out of money on the day you die then you probably were cutting it a bit too close. Target date funds tend to load up on bonds as retirement approaches even though the investor might have 20 or 30 more years to live after retirement, which we think calls for a much higher equity ratio than most target date funds have.
Secondly, though we don’t think you should try to time the market with big bets, it’s important to be able to adjust to changing market conditions. For example in this low-yield environment with the threat of inflation, we might want some portfolios to hold more equities than would have been prudent ten years ago, but shift into stocks that pay dividends as bond substitutes. This kind of adjustment would be impossible in target funds that run on autopilot.
Finally, we believe in the idea of stewardship, that an investor has a responsibility to know what he owns. A money manager must know the individual securities in his portfolio, their risks and their strengths, and their suitability for the client. Likewise, the advisor should give the asset allocation serious consideration based on both the market and the client’s situation. While this discipline won’t necessarily improve short term performance, it often pays off in times of crisis and market excess. When the whole market goes down a lot, as it has in recent days, it helps to know that you own high quality stocks and bonds in companies with real products and services that are growing and innovating and will outlast the short-term market fluctuations.