Do Target-date retirement funds work? (Interview with Principal Funds)

Target-date retirement mutual funds have become hugely popular over the last five years. retiree-photo-by-ginny-austinThe concept is simple: Instead of having to constantly adjust your asset allocation between stocks and bonds as you grow older, you invest in one fund that does it for you. Invest in the Company X Target-Retirement 2020 fund this year, for example, and they might have you allocated 60% in stocks and 40% in bonds. Ten years from now, when you’re only a year from retirement, the fund might have automatically moved your money into a more conservative 50%-50% mix. It’s an easy, set-it-and-forget-it alternative to having to rebalance and reallocate your portfolio every year on your own.

Sounds good, right? Well last year, retirees found out why these funds aren’t no-brainers after all. Vanguard’s Target-Retirement 2010 fund dropped 20% in 2008. That’s quite a hit for someone who’s starting to withdraw money. According to a T Rowe Price study, if the market returns 0% to 5% in your first 5 years of retirement rather than the higher market-average, your chances of running out of money in retirement double. Unless those funds show a really strong upswing soon, holders of retirement income funds might be in serious trouble.

I interviewed David Reichart, the head of business development for Principal Funds, about the issue earlier this week. Principal’s 2010 fund dropped 31% last year. Here’s an excerpt:

Joe: Do you feel like the fund was allocated too aggressively? What went wrong?
David: You can point to a lot of sources for the negative returns, but the lion’s share just came from pure equity exposure. If you look at your equity exposure as you near retirement…let’s say you had 50% in equities. Somebody might say “Well, gee, how can you afford to have that much in the market because it may go down 40% or 50%? No wonder you were down 30%.” But people should understand that when you talk that way, you’re only talking about market risk. The biggest risk for a retiree entering retirement is longevity risk — the prospect of outliving your wealth. You’re going to run out of money if you don’t have equity exposure.

David’s point is a good one. If a retiree panicked and put all of his money in Treasury bonds right now, his money might only gain 2% a year. Depending on how much he’s saved up, while his portfolio won’t go down, he might be nearly guaranteed to run out of money before he dies.

But target-date retirement funds don’t capture the whole picture. Let’s say you’re retiring at 66 years old, need a retirement income of $40,000 a year (in addition to Social Security and inflation adjustments), and have $1,000,000 in savings. That person might very well need stock-like returns to not run out of money.

But what if a similar 66-year old lived frugally, and had saved up $4 million instead? If he still just draws down $40,000 a year, he won’t need the same level of returns as the first guy. So, to protect himself from the remote possibility that the market has a massive heart attack (as it did last year), he might only put a small fraction of his money in stocks.

Target-date retirement funds treat everyone the same. And as a result, they don’t give those super-savers the chance to whittle their risk down to the level that they’ve earned by penny pinching before they retired. They’re still better than not asset allocating at all, but they’re probably a little oversold as the end-all and be-all of mutual funds.

Update: For a more recent post on target-date retirement funds, click here.

– Joe Light

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5 comments so far

  1. freemarketswork on

    Good Post and interesting points. The bad part about Target funds (and the mutual fund industry) is that nobody is accountable for their actions and the investor suffers because of the manager’s decisions to allocate 50% in equities in a fund for people retiring next year!!!

    • Alison on

      It seems to me like the Target funds are more suitable for younger investors, with time on their side. Even the least sophisticiated older client should be evaluating their positions more frequently as they edge closer to (and through) retirement, to be certain they line up with their goals.

  2. […] Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds. […]

  3. […] Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds. […]

  4. […] Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds. […]


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