Strategies on Choosing Retirement Investment

I gave the couple a risk tolerance questionnaire. (It is considered malpractice, by the way, for a registered investment advisor not to have clients complete a risk tolerance questionnaire prior to doing any investing.) In this case I was doing it only for the purpose of their retirement planning. They both scored in the moderate range for risk tolerance. However, that is not the risk tolerance their target-date mutual fund is currently operating on. Let’s take a deeper dive into these strategies.

401(k) plan and 403(b) plan default choices

The responsible plan fiduciaries of your 401(k) or 403(b) plan can choose to offer a qualified default investment alternative (QDIA) in an effort to help employees make better diversified portfolio investment decisions. Many people find that in the rush of their employer’s on-boarding process, they do not spend much time thinking about their retirement choices. In addition, I think the naming of target-date funds has made them the most popular choice.

The less well-known qualified default investment alternative strategies are balanced funds and asset allocation funds. The balanced fund typically has 60% stocks and 40% bond. Your company also may offer a menu of risk-based, asset allocation funds of varying risk and return characteristics, ranging from conservative to aggressive risk. The asset allocation fund expands that set of options to 80% bonds and 20% stock, 40% bonds and 60% stock, 50% bonds and 50% stock, 60% stocks and 40% bond, 80% stocks and 20% bonds and possibly 100% stock. Your company likely would have chosen one of the choices in the middle, such as the 50% bonds and 50% stock as their qualified default. (Target-date funds take the asset allocation funds and vary them over time. Essentially you have multiple asset allocation funds.)

As you may imagine, not all mutual fund or portfolio managers have the same percentage or same type of stocks and bonds in their asset allocation funds. For example, some may have 75% bonds and 25% stock rather than the 80% bonds and 20% stock choice highlighted earlier. Some of them may use international bonds, government bonds, international stocks, emerging markets stocks, value stocks and a host of other categorizations of investments. As you can see, it’s not easy to compare the asset allocation funds of one provider to another. Now let’s complicate it further with the added wrinkle of the target date.

Understanding the target date glide path: “to retirement” or “through retirement”

You may expect that the target-date fund gets less risky or reduces its exposure to the stock market as you approach retirement. You would be correct if your company is following a “to retirement” glide path. If it follows a “through retirement” glide path, that reduction comes later—say five or 10 years after you retire. There is no common agreement among all providers of target-date funds about which approach is correct. Some research even suggests rethinking the glide path altogether. Maybe it should be the inverse, for example.

It is difficult to compare target-date mutual funds from different companies. If the market is currently up, a “through retirement” strategy will likely have a higher return simply because it has higher exposure to stocks. You would then want to make sure that you are comparing it to another target-date mutual fund that also uses a “through retirement” strategy. Let’s say the following year the market is down, in that case you would have preferred to be in the “to retirement” strategy that would likely have had a lower percentage of stock exposure. In either case, the specific types of investments inside the portfolio, sometimes known as asset classes, may also be the reason that one strategy has more return than another. Having more return doesn’t necessarily increase the size of your balance, however. Typically, it is better to have a portfolio that has less up and down movement, known as volatility, than one that has more. That’s true because the portfolio that declines more must work harder to get back to even. A big return does not mean that it has gotten back to even.

You may also have heard of the camps of thought regarding active investing or passive investing. Active investing is typically associated with a specific investment trying to beat the market index it compares itself to. Asset allocation funds are usually made up of multiple underlying investments. The odds that all of them would beat their specific market index is extremely low. Passive strategies are associated with simply trying to get as close to the market index as possible. When we are talking about portfolio construction, the true active component is in the work to develop the asset allocation. In the case of target-date strategies, the glide path is an active component as well.

As you can see, there are many moving parts. At minimum, you should find out if your target-date mutual fund has a “to retirement” or “through retirement” glide path. Next, depending upon your age, you should find out what your current asset allocation looks like. Are you in the predominantly bond side or the predominantly stock side? If you are in the bond side and are just starting to save, you shouldn’t expect much in accumulating value. If you are in the higher stock side, you should expect greater swings in your account balance it’s weighted toward stocks.

Takeaway

Most people are better served by finding an investment adviser representative who can help them customize a portfolio from the choices inside of their plan. This type of financial professional can charge for the customization without having to manage the investments. Ideally your investment advisor representative has some advanced designations in retirement planning, such as chartered retirement planning counselor, retirement income certified professional and certified financial planner.  Your plan customized retirement plan should consider inputs like your anticipated Social Security and pension income, money you have already saved, your future tax liability, whether you are expecting to use your health savings account for retirement, etc. If you are setting up your own IRA, Roth IRA or possibly your own Solo 401(k), you may want to develop a personalized retirement plan prior to deciding on your investments. How much you can save, and how long you plan to work will affect your expected accumulated retirement balance. Having the retirement balance you need at your target date is what really matters.

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