A Targeted Tale
A Targeted Tale
(You Are the Target)
This is a tale that looks into your future and the quality of your financial future. I call it a Targeted Tale because it targets your retirement date. It isn’t very complicated and is simply meant to encourage two ways of thinking. The first is to encourage you to avoid investing in target dated mutual funds for retirement purposes and instead learn how to be a competent do-it-yourselfer. The second is to remove any misconception about retirement as a particular date in time since the day you retire is only day one of your retirement. Hopefully there will be many days after and you will be just as responsible for your money after retirement as the day you retire.
Before we go too far let’s first talk about a fairly new investment product called a Target Dated mutual fund. It is a mutual fund with a date attached to it such as the 2050 fund or the 2030 fund or the 2040 fund. They are typically included as one of the investment options in most retirement plans but are also available for personal investments outside of a retirement plan.
What the date in the fund means is that if you are 30 years old for example and plan to retire in 35 years and today’s year is 2015, then you will be 65 in the year 2050. So you would elect to invest your money in the 2050 fund. That is it. If you were 40 years old you would invest in the 2040 fund and if you were 50 years old you would invest in the 2030 fund. The concept behind the funds is simple. Give us your money for 15, 25, 35 years and one of our professionals will manage the money for you by setting up a diversified portfolio of stocks, bonds and cash that we think is appropriate for your current age. What could be simpler? The answer is nothing and the reason why these funds are growing in popularity and will be around for a long time I suspect.
Let me say this about target dated funds which is very different from what many advisors say. I give them a grade of B and not a D. They have disadvantages but they have one huge advantage. They protect you from yourself. They mitigate most of the behavioral biases that either once made retirement plan participants gravitate towards low return investment options or manage their portfolios in an undisciplined manner. So all said and done, these are products that certainly deserve to be options in a retirement plan and if you are the type of person that you will read about soon, it is definitely for you. However, they don’t get an A grade because they do have disadvantages.
As an aside, target dated mutual funds have morphed nicely since they first came out and many are now reasonably priced. They are still more expensive than if you did-it-yourself because they add a layer of costs in order to provide the packaging. They are still very divergent in how one firm manages their target dated mutual fund vs. another which means not all target funds are the same even the ones that target the same date. Lastly, they are probably either too aggressive or too conservative for your needs and risk appetite. But I don’t find this a problem since if you are inclined to invest in one of these it means you probably are the type of person that simply has no interest in learning and would also have no interest in understanding about your needs or risk appetite. Is it the end of the world? Probably not and you can see why.
Let’s take two 30 year old identical twins that each plan on retiring at age 65 and let’s look at the difference between the twin that invests in a target dated fund, we’ll call him Target, and the one that learns how to be a successful do it yourselfer and we’ll call him Solo. Let’s assume the only difference between the two is that Solo saves a ½% per year fee because he does it himself. So assuming they each make $50,000 a year at age 30 and their salary increases at 3% per year until age 65 and that their portfolio averages 7% per year what’s the difference? The answer is not much. Solo has about $1.525 million dollars saved at age 65 and Target has $1.382. Solo has approximately 10% more money than Target at their retirement date. Once again, the difference is 100% attributable to the ½% fee that Solo saved by managing his own portfolio. Fees matter.
If it were this simple, I would advise everyone to invest in a target dated mutual fund. In my opinion the fees certainly justify the differential. I personally would pay the $143,000 difference to never have to worry about managing my own money if I were so inclined. I could devote my life and time to the pursuit of other more enjoyable activities. However, it isn’t this simple. There are complications. What are those complications?
There are two major complications. The first complication is that Target will probably not average the same rate of return as Solo. If I had to estimate the rate of return differential it wouldn’t just be the ½% paid in fees. I think that is justified. I would add an additional 1 ½% rate of return differential between Solo’s and Target’s portfolios. It can go either way in my opinion. Solo might make 8 ½% while Target makes 7% or Solo might make 7% while Target makes 5 ½%. The reason I say this is because target funds are managed based on a formula. While the formula differs for each vendor it has one thing in common. The commonality is they all reduce the allocation to the stock market as the participant gets closer to the retirement date. On average, but not always, this represents a large drag on performance.
Now things are getting more interesting and Target is having second thoughts about target funds. He does some quick math and sees that if he could make 8 ½% like his brother Solo by doing it himself he would have almost $688,000 more at retirement or 50% more than before. We are talking about real money now and Target is fully focused. He then says, ok what if Solo can make 7% but my target fund only makes 5 ½% and I pay the ½% fee? Guess what, Solo once again has almost 50% more money than Target. It is about this time that Target signs up for some How To classes.
I wish it were this simple however. There is one further complication that no one seems to point out. Just like chess has an end game so does retirement. It seems no one pays attention to what happens to those people, like Target, that reach retirement age and have only invested in target dated funds and are thus investment illiterates. Guess what? They stay illiterate and for their sake that is a good thing because the last thing a person should do with a large sum of money at age 65 when they’ve never had to make investment decisions is to start making them at this point in time. What typically happens is a person like Target will roll their retirement money into a guaranteed but low paying instrument such as an annuity, bank deposit or conservative bond.
The investment industry has no real solution for a person like Target. By the time he reaches age 65 they’ve babied him for 35 years and now present him with some very bad choices. They let him avoid personal responsibility and now he hopefully has many years ahead of him but he’ll have less money than his brother, a lot less money. Furthermore, the likelihood that he will run out of money is higher and if he doesn’t it is almost certain that he will leave a smaller estate or legacy. There is a price to pay for ignorance and target dated funds are designed to conceal this price. While on the surface they appear wonderful, they have ramifications that are far-reaching and why I give them a grade of B. Why a B you may ask? Why such a high grade? The answer is simple, while I advise against these types of investments you have to give the devil his due. I recognize they promote savings in retirement plans and promote a higher allocation to stocks than most people would select if left to their own methods. Furthermore, there is very little evidence that people like Solo can even outperform a target fund if they don’t approach it seriously.
I urge you to take the time to learn how to be better than a target. The next time you hear the word target fund, change your thinking from a target date for your retirement and instead think “I am the target.”
If you want further information, feel free to contact us at www.financialtales.com.