You’ve been managing your own retirement savings for some time. However, the task is becoming more overwhelming, so you decide to work with a financial adviser. You tell the adviser that you would like him to design a retirement portfolio that is appropriate for your individual needs.
Your advisor asks you’re the following two questions. What is your current age? What year do you plan on retiring? After your response, he tells you that he has the perfect portfolio for you. How much confidence would you have with that investment strategy?
This is exactly how target date funds manage money. The only two factors these funds use to make investment decisions are a person’s age and the year in which they plan to retire. That’s it, nothing more.
Since first introduced in 1994, target-date funds have been marketed as a fund that can help take the guesswork out of saving for retirement. You simply pick a fund with a year in its name (i.e., 2020 or 2030) that is closest to the year when you plan on retiring, and invest your 401(k) and or IRA savings into that fund. The simplicity of this “set it and forget it” approach to investing has caused the popularity of target-date funds to increase substantially, particularly within participant-directed 401(k) plans. Since 2008, target date fund assets have grown from approximately $158 million to over $1.1 trillion as of Dec. 31, 2017.
If only investing were that simple. Unfortunately, there is a significant flaw with this approach to investing. Not every individual who plans on retiring in the same year should have the exact same investment portfolio. Just because two people who are the same age or plan on retiring in the same year on doesn’t mean they have the same investment goals, or need to take the same amount of risk to achieve those goals. The accompanying chart illustrates this point. There are two 50-year-old employees who both plan on retiring in 16 years when they are 66 years old. They would each like to retire with $1 million dollars in savings, and they are both saving for retirement in their 401(k) plans 2035 target date fund.
The first employee currently has $300,000 saved and plans on saving $5000 each year over the next 16 years. The other employee currently has only $200,000 saved and also plans on saving $5,000 each year. Despite being the same age, and having same the goal to retire in the same year, with the same amount of savings, the two employees have two very different financial situations. The first employee only needs an average return of 7 percent to achieve his goal of retiring with $1 million. The second employee however, needs an average return of 9.5 percent to retire with $1 million. This 2035 target date portfolio is obviously not appropriate for both employees.
When it comes to investing, there is no such thing as a one-size-fits-all portfolio. There is no single asset allocation that will work for everyone. Not everyone has the same goal, time horizon, risk tolerance or circumstance. An investment strategy must take into account how you will achieve your goals, given your financial situation. It should be tailored to meet your goals because your situation is different than anyone else’s. A target date fund is not based on any of these things.