One of the common funds found in retirement plans today is the target date retirement fund. If you have a 401k plan through one of the major brokerages, you will likely find target date funds in it.
The idea is that you can invest in a fund that will allocate your money into assets that line up with your retirement date. It is assumed that most people will retire around the age of 65. As your target date approaches, the fund will get more conservative and less risky, or at least that is the idea.
If you were born in 1970, then you will turn 65 in the year 2035. You would then pick the retirement fund with a target retirement date of 2035. If you were born in 1980, then you would pick a retirement fund with a target date of 2045.
I believe these exist in increments of 5 years. I haven’t seen any retirement funds with more precise dates. So if you were born in late 1982 or early 1983, should you pick the 2045 retirement fund, or the 2050 retirement fund?
This may be a slight drawback to these funds, but I don’t think Vanguard and Fidelity want funds for every possible retirement year. In the above example, someone could pick one or the other, and it wouldn’t have that much of a difference. You could also split your money between the two funds.
Another thing to consider with these funds is that not everyone is going to retire around the age of 65. There are some people who plan on working well into their 70s.
There are also people who are pursuing the FIRE life (financial independence, retire early). There are people who want to retire at the age of 40. Of course, for a person in this situation, they won’t be able to access their retirement money in a 401k plan until age 59 ½. If they withdraw it any earlier, they will get hit with a penalty in most cases. So an argument could be made that even these people should invest in the retirement date funds as normal. Maybe they could target when they will hit age 60.
For most FIRE people, they are quite involved in their personal finances, so these people will figure out their needs.
There is an article on Investopedia describing the advantages and disadvantages of target date funds.
One of the disadvantages listed is that not all of the funds are the same when comparing different brokerages. There are slight variations in the allocation to equities and bonds. Within the equities portion, there are variations in the allocation toward international stocks.
The article also mentions expenses and how they can add up. I would say this is a minor drawback, as the expense ratios for these funds are dropping and are very low as compared to what they have been in the past.
The Number One Drawback
It is curious that these conventional articles just don’t mention the number one drawback. To me, the biggest problem with these funds is the lack of diversification.
First, there are really only two categories at play. There are equities, which are stocks. And there are fixed-income assets, which is mostly bonds and maybe a little bit of short-term assets that are like cash.
There is no focus on real estate or commodities. You could pick up a little bit of exposure in the equities portion indirectly though.
It doesn’t provide a very good hedge against a situation of high inflation. If we went through a period like the 1970s and early 1980s, these funds would get crushed. Stocks do not always serve as a great hedge against inflation. They certainly aren’t the best hedge.
But there is also a problem of deflation and recession and depression. If you look at the examples from the Investopedia article, it gives three examples of 2045 target funds. This was written in 2020, so it assumes a person born around 1980 who is 40 years old. This person will turn 65 in 2045.
The current allocation (in 2020) shows all three funds with the equity portion above 90%. To allocate 7 to 9 percent to bonds and the rest to stocks is absurdly risky.
I understand all of the arguments that someone at this age has time to recover. This hypothetical person has 25 years and has plenty of time to ride out any bear markets, so the experts say.
We are told that 25 years is a long time horizon, and historically stocks always go up in the long run.
Tell that to the Japanese investor who put money into the stock market in 1989 and is still way down from that point over 3 decades later.
There is a legitimate retort that most people will not be dumping all of their money in at once, and it won’t be all at the top of the market. But still, the Japan example (which is a first-world nation) shows that the stock market can basically go stagnant for a long period of time.
This is not a prediction of what will happen in the United States. It is only to say it is possible.
And here in 2021, we are in a massive and unsustainable bubble. The only way this thing doesn’t come crashing down is if we see massive price inflation. And even then, we will likely eventually see a major market downturn from where we are.
And if a long period of high inflation does prevail, then stocks probably aren’t going to be your best investment anyway.
This is why I advocate using the permanent portfolio as a place to start. You can tweak it to your own situation and even make it a little more aggressive if you are young. But I believe that should be your starting point.
I don’t think it is a good starting point for a person who is 40 years old to have over 90% of his or her retirement account in stocks.
What happens if stocks drop by 50% and stay down for a while? What happens if they drop by 80% and we have a prolonged depression?
Again, I am not predicting these things, but I am pointing out that they are possible.
Even if someone is continuing to contribute, that would be a massive hit. If the 40-year old person has $200,000 saved up, a 75% drop in stocks would hit over 90% of this amount in the target fund. How would this person like to open up the latest 401k statement and see that $200,000 went to $70,000?
It gets even worse for those close to retirement. Take the Vanguard Target Retirement 2030 Fund. This means someone will be retiring in approximately 9 years. Vanguard still has this at over 66% in stocks.
While I love Vanguard’s low-fee index funds, this retirement target fund is absurd and completely irresponsible.
Let’s imagine someone who is 56 years old and planning to retire in 9 years. Then stocks crash. That two-thirds portion in stocks takes a hit of 80%. Maybe the smaller portion in bonds goes up 10%, although there is no guarantee that bonds will go up in value (interest rates decline) with a stock market crash.
Let’s say this person had one million dollars sitting in this retirement fund with a target date. About $660,000 in stocks drops to $132,000 (80% drop). About $340,000 in bonds goes up to $374,000 (10% increase). That leaves this person with $506,000. That million-dollar retirement portfolio essentially just got cut in half with only 9 years until retirement.
Perhaps I should say that it was supposed to be 9 years until retirement. If the market doesn’t recover quickly, then this person will not be retiring as planned, or will be doing a lot less in retirement than what was planned.
In summary, I understand that these target retirement date funds are there for simplicity. They are for people who don’t really know what they are doing in terms of investing, which is most people.
The problem is that these funds are very heavy in equities. They would have served most people well over the last 40 years. But past performance does not guarantee future results. That is the problem.
We are living in an unprecedented bubble. Maybe it will keep going for a while. Maybe it won’t. But it is setting up many millions of people to take a drastic hit in their portfolio if and when stocks crash. The people in these target retirement date funds may have to change their retirement date when things get bad. I don’t know if they will change their fund.
It won’t look good for these major brokerages when someone is looking at their 2030 target retirement date fund in 2035 when they are still working.