Are Target Date Funds Really Helping Employees?
If you have a retirement savings account, you’ve likely heard of target date funds, or you might already be holding one.
A target date fund is a mutual fund or ETF that invests assets to target liquidation for a certain event in the future. They are most used for retirement savings, like 401(k) plans or IRAs. The funds are designed so that the participant can select an estimated retirement date and pick the corresponding fund. The fund purports to properly invest your assets towards your retirement. It sounds simple right? But there’s a lot more you need to know; these widely used retirement funds usually don’t align with investors’ unique financial needs.
Let’s step back and look at how target date funds became a popular retirement investing vehicle. Employers act as a retirement plan’s fiduciary, meaning they have a legal obligation to run the plan in the interest of the employees. Before 2006 defined contribution plans like 401(k)s had low participation rates and most of the assets weren’t even invested. Cash was the most risk-averse option for employee accounts that didn’t have any investment elections. You can’t lose if you’re in cash, but that doesn’t help the employees trying to grow their retirement savings or provide an inflation shelter.
The Pension Protection act of 2006 was the government’s way of helping employers boost plan participation through automatic enrollment and getting all that cash invested via a Qualified Default Investment Alternatives (QDIA)—the default investment option for defined contribution plans, like a target date fund. These reforms provided employers with a safe harbor against fiduciary liability—meaning the employer is no longer on the hook if employees lose money in the markets. The problem was that target date funds solved a problem many employers had, but didn’t address the retirement needs of the millions of employees actually invested in them.
The only thing investors in target date funds have in common with one another is the year they plan to retire. Imagine going to your doctor and having them write you a prescription based solely on your age; prescribing cholesterol medication simply because most people your age take cholesterol medication? You might not feel confident in the advice. This is similar to the solution proposed in target date funds. Simply knowing the year in which you plan to retire tells a fund manager nothing about your unique situation; so it’s a reach to believe they’ve developed an efficient investment allocation that considers things like your cashflow tax and risk needs. Unfortunately, managers are unable to tailor the fund to fit the needs of those two investors or the other millions of investors holding the fund.
Target date funds are just focused on a retirement date, but most people’s goals are more numerous than just quitting work. Especially when we include things they might want to do once they retire! There are four major items we consider when developing an asset allocation for our clients: financial goals, time horizon, risk profile, and tax.
Many investors will need to withdraw funds from their savings for events other than retirement income, like helping a grandchild with college expenses or paying for a wedding. These goals have a different time horizon than just a retirement date. So, as financial planners we look at future cashflow needs beyond retirement income and create a timeline for when those withdrawals may occur. These cashflow projections change your allocation because the timing and size of withdrawals matter in the context of an investment strategy.
Risk tolerance is another key element in developing an asset allocation because it determines the best balance of stocks and bonds in your portfolio, which is the most important factor in successful investing. This also helps you will stick with an investment strategy through market swings so you can continue making money long-term; otherwise, you’re likely to fall into a buy high, sell low strategy—a quick way to lose all your savings.
At Camelotta we employ behavioral finance research embedded in a questionnaire developed at MIT to learn our clients’ psychological risk tolerances. We do this without asking them finance-related questions. For example, most people don’t know how to answer the question “what would you do if the market sold off by 20% tomorrow?" because a hypothetical is different than the reality of being faced with that situation—at which point it’s too late. By learning about a clients’ natural behavior towards risk and applying this to their investment strategy we minimize the chances of a client being unhappy with their portfolio, which maximizes their wealth.
Another element of investment strategies that target date funds can’t address is tax minimization. Some investors have multiple retirement savings accounts like a 401(k) (tax deferred account), Roth IRA (tax-free account), and they might have a taxable brokerage account after exhausting savings into the retirement accounts. Each of these have different taxation rules so it’s often beneficial to use different allocations within each account to maximize post-tax wealth—like placing high tax investments in a tax-free or deferred account. Target date funds can’t do this because they have no way of knowing what type of account the fund is being used in nor do they have knowledge about outside assets the investor may have. They assume the participant will make this determination.
For example, Vanguard recently made headlines for a related issue after investors in their target date funds spoke out about the high tax bills they faced after Vanguard reduced the minimum investment size of their institutional target date fund series from $100 million to $5million. Consequently, many more retirement plans now qualified for the institutional shares, so those plans sold their shares in the regular series and bought into the institutional series. The managers of the regular fund series then had to sell the mutual fund’s holdings to generate cash for the investors pulling out of the regular fund series. This produced high capital gains for those left holding the regular series target date funds at the end of the 2021.
For investors holding the Vanguard target retirement funds in a tax free or tax deferred account, they didn’t have to worry about the high capital gains. However, investors holding the fund in a taxable brokerage account incurred high taxes—the average Vanguard capital gains distribution was 12.1% in 2021, compared to an average of less than 1% in prior years. A tailored asset location strategy helps investors avoid large tax bills by strategically placing high tax assets in tax-free or tax deferred accounts.
Target date funds are a one-size fits all investment strategy that is not ideal for anyone. With a little bit of financial planning, investors can develop a personalized investment strategy so they can more effectively achieve their financial goals. This should be the gold standard for 401(k) plans since it is the largest retirement savings vehicle for Americans. A better alternative for target date funds is to work with a financial planner or investment advisor to tailor the investments in your retirement account. At Camelotta Advisors we act as the plan fiduciary for 401(k) plans so employers can address fiduciary requirements (the point of target date funds), while helping employees utilize the 401(k) plan to help save towards their individual goals.
Copyright 2022 Camelotta Advisors, All Rights Reserved. The commentary on this website reflects the personal opinions, viewpoints and analyses of the Camelotta Advisors employees providing such comments, and should not be regarded as a description of advisory services provided by Camelotta Advisors or performance returns of any Camelotta Advisors Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Camelotta Advisors manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
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Camelotta Advisors is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Camelotta Advisors and its representatives are properly licensed or exempt from licensure. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Camelotta Advisors unless a client service agreement is in place.
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