TARGET DATE FUNDS

For those of you who struggle with deciding upon which funds to choose for your 401K, I will be reviewing all of the different categories of funds available to 401K investors. Today, I will be focusing on one of the common 401k investing options - target date funds.

HR departments and most 401K plan administrators tend to push target date funds to their employees. Target date funds are not a bad option. They are just not the best option.

Target date funds are balanced funds that use the asset allocation method covered previously. Target date funds are tied to the age of the employee based on their expected year of retirement. You might see Target date fund options in your plan labeled 2040 or 2050 for example. The year in this case, 2040, indicates the year that the employee is expected to retire.

Based on the age of the employee, a target date fund automatically rebalances the investments in that fund between stocks and bonds. The old industry adage is that younger people should have most of their money in stocks and very little in bonds. As people age, they say that people should decrease their stock investments and increase their bond investments. The reasoning behind this is that stocks on the whole are more volatile than bonds. If the stock market nosedives, a younger person has more time to wait for the stock market to recover. A person nearing retirement doesn’t have as much time for the stock market to recover so they are encouraged to put a higher percentage of their investments in bonds.

In a target date fund, a typical employee might see their portfolio average out to a split of 75% stocks and 25% bonds over the course of their working life. Younger 401K target date fund investors may have 90% in stocks and only 10% in bonds. Older target date fund investors may have only 60% in stocks and 40% in bonds.

Target date funds also tend to allocate their stock investment across the various subclasses of stock funds – large cap, small cap, international stocks, value funds and growth funds for example.

The next table shows the results for Target Date funds or Balanced funds. I am using Vanguard’s Target Date funds since they are used quite a bit for 401K plans and because Vanguard is a good performing asset manager with low fees. Target Date funds only became popular less than 20 years ago so we can only compare the 10-year performance results.

From these results you can see evidence of what I pointed out earlier for target date funds. When a person ages, Target Date funds shift more money out of the stock market and into the bond market. Since bonds have much lower investment returns than stocks, the overall returns from target date funds are higher when a person is younger. You can only expect to earn about 6.5% per year in Target Date funds over the long run.

The performance of Target Date funds is also negatively affected by the stock investments that they choose for their funds. These funds take the balanced approach one step further by including different types of stock investments. They like to include international stocks in their assortment as well as small-cap and mid-cap stocks. This, too, lowers investment returns as you saw from the previous analysis of the results for these kinds of stock investments.

The performance of Target Date funds also highlights a point that I make frequently - that the Asset Allocation method pushed by the investment industry doesn’t work. The Vanguard 2040 Target Date fund that has produced a 6.5% annual return over the last ten years lost 17% in 2022. The S&P 500 Index produced a 10.9% annual return over the last ten years and lost 18% in 2022. So, the asset allocation method reduced losses by only 1% in the bear market of 2022 but it lowered average annual returns over the most recent ten year period by 40% (from 10.9% down to 6.5%).

Target Date funds are the default option of HR departments and plan administrators because they are deemed to be safer. But that supposedly safer option comes with significantly lower returns than the large-cap index funds. Those lower returns are costing 401K investors hundreds of thousands of dollars or even millions of dollars over their working life.

A much better way to obtain the safety that Target Date funds are supposed to provide is by using our Market Signals investment service. You can potentially double your investment returns and get the peace of mind of knowing your money will be protected in a market crash.

Happy Investing,

Phil

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