Playing It Safe Could Make Retirement Riskier

Have target-date-funds become too conservative?

by Matthew Dicken

When target-date funds (TDFs) emerged three decades ago, they solved a number of problems for retirement investors. For employees dealing with the shift from pensions to 401(k) plans, TDFs provided an easy way to keep investments properly balanced. TDFs also provided a low-cost option for retirement savers in an era when access to low-cost index funds was limited. Overall, TDFs were seen as a safe option for those seeking to optimize their retirement savings.

Today, however, advisors and the clients they serve are questioning how effective TDFs are at derisking retirement savings. Americans are now living longer, working longer, and facing new financial challenges in their retirement years. As a result, identifying a target date and optimizing portfolios to serve that date isn’t as straightforward as it once was.

One of the key questions advisors are asking is whether TDFs have become too conservative for retirement savers. Risk management is still the goal, but the strategies needed to achieve that goal are being revisited as the factors in play shift.

As Retirement Timelines Shift, Traditional TDFs May Be Sacrificing Growth Potential

On average, those retiring today will need their investment proceeds to last 20 to 25 years. But some suggest that we could soon live much longer than we have historically expected due to medical advancements expected from the use of artificial intelligence in the medical field.

As longevity increases, so too does the possibility of a longer career. Studies are already showing that a growing number of Americans are working past the traditional retirement age. While several factors are influencing the trend, from a challenging economy to Social Security reforms, the outcome is the same: shifting retirement needs.

With TDFs, the risk for those working longer is sacrificing the potential growth needed to keep pace with inflation and support a longer retirement. As their name says, TDFs are designed around a “target date” when retirement disbursements are expected to start. If a delayed retirement shifts that target date, the shift toward conservative investing will occur too soon and last too long, robbing investors of a longer period of growth investing.

While less common for today’s investors, TDFs pose a similar risk to those who must retire earlier than expected. In those cases, investors can be impacted by short-term volatility that TDFs are designed to eliminate as retirement age approaches. In either case, the issue is that TDFs assume a general timeline, which can fail to effectively serve an investor facing unique circumstances.

The Simplicity Of TDFs Can Cause Investors To Ignore Key Economic Issues

Target-date funds were designed to make retirement investing simple. They did away with the need to understand and consider concepts like glide path design, systematic rebalancing, and interest rate sensitivity. An investor using TDFs simply needs to pick a fund based on an expected retirement year, and the portfolio driving returns would automatically become more conservative over time.

For novice investors, TDFs provide the diversification needed to minimize risks while also removing much of the decision-making that can make investing intimidating. One might think of TDFs as an “easy” button for their investment selections. Those who are perplexed by the differences between large-cap, emerging markets, and TIPS funds can optimize their returns — at least theoretically — by simply identifying how many years they have before retirement.

But just as an “easy” button doesn’t necessarily work in real life, assuming retirement planning will be easy can create serious risks during retirement. By oversimplifying the investing process, TDFs introduce weaknesses into the investment strategy.

A TDF essentially makes major investment decisions based primarily on one’s age, which is a very limited view of someone’s financial situation. When TDFs adjust investment profiles, they don’t take into consideration factors that can have a major impact on returns, such as the current interest rate environment, market conditions, or sector concerns.

Retirement Investors Must Look Beyond Age To Optimize Returns

To address the weaknesses TDFs bring to retirement investing, advisors and their clients must acknowledge that age is only one piece of the equation. As pre-retirees seek an optimal strategy, they must also consider a long list of other factors that play a role. These include:

• Income needs
• Social Security income
• Existing pensions
• Other assets
• The impact of tax obligations
• Liquidity needs
• Individual risk tolerance
• Estate planning goals
• The time period for which retirement funds might need to last

With so many variables, optimal strategies are sure to vary widely from investor to investor. TDFs ignore those variables, assuming that two people should have essentially the same portfolio simply because they are the same age.

Retirement savers need to see retirement as more than a destination. They need to understand it as a transition to a new lifestyle. The more they can define what that lifestyle will look like, the better they can align their investment strategy to support it.

As Longevity Increases, Retirement Investors May Need To Be Less Conservative

As mentioned above, TDFs emerged in a time when lifespans and career spans were different. They were based on strategies that acknowledge a common milestone (age 65) and an expected disbursement period after that milestone. Consequently, they initiated a shift from growth to conservative investing based on those considerations.

Now that people are living longer and working longer, the effectiveness of the parameters traditional TDFs were built around is being called into question. And in many cases, investors can’t be as conservative in their retirement investing as they once were.

When investors stick with strategies that are too conservative for today’s retirement realities, they create risks. A retiree who may live another 30+ years still needs growth as they approach retirement. In fact, they may still need to be growth-focused after they retire.

One important financial truth to keep in mind is that inflation compounds over long periods. In the past, retirement years were short enough that they weren’t heavily impacted by compounding inflation. Today, however, an overly conservative portfolio may preserve account values in the short term while reducing purchasing power over time.

It is important to remember that retirement doesn’t necessarily mean an investor suddenly has a short investment horizon. Some people will have a retirement that’s just as long as the number of years they worked, if not longer.

Investors Need To Carefully Consider The Value Of Target-Date Funds In Today’s Environment

As investors consider making TDFs a part of their investment strategy, there are a number of questions they should ask, including:

• How much stock market exposure does the fund have today?
• How conservative does it become at retirement?
• What assets does it own?
• What does it cost?
• Does the glide path continue changing after retirement?

The answers to these questions will be crucial in determining if the fund will help an investor meet the unique goals they have set for their retirement. But the most important question to ask when considering a TDF is whether a generic age-based strategy is really appropriate for their financial situation.

For someone just beginning to invest, a TDF can be far better than having no strategy at all. But as an investor becomes more financially sophisticated and accumulates meaningful assets, the portfolio should increasingly be built around that individual’s specific goals rather than simply their expected retirement date.