I was talking with a young couple the other week regarding
their retirement investment selection in their 401(k) plan. They both had selected
choices based upon their retirement age. They will hit that age in 2050. If you
aren’t retiring for 30 years, that might seem like a good choice. But what does
that year really mean when it comes to investing for retirement? This type of
investment approach is typically referred to as a target-date strategy.
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
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
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,
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.
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
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