The key to growing money in a long-term retirement plan is to be as broadly diversified as possible.
That is, to be broadly diversified in an age-appropriate fashion. With investments it’s particularly important for us to act our age.
Some will argue for the merits of a risk-adjusted diversification, and certainly risk tolerance is not an unimportant factor in the equation. But a snapshot of an investor’s risk profile is almost like a depreciating asset. It immediately becomes dated, and the further we move away from that snapshot the less value it provides. (THINK: Driving the car off the lot.) Yesterday’s risk profile is practically useless, due to time and any number of other circumstances that could alter one’s risk tolerance.
Since time (and time-horizon) is such a huge factor in the formula for success, a factor easily measured by our age, it makes far greater sense to use an age-appropriate diversification rather than a risk-adjusted diversification. After all, most retirement plan participants don’t revisit their initial investment choices, or don’t revisit them often enough to be relevant data points.
Generally speaking, younger investors should be more aggressively invested, and older investors should be more conservatively invested. The nice thing about a Target Date Fund is that it “forces” us to act our age, and to invest in age-appropriate ways.
Given one’s personality and risk aversion, some younger investors might (incorrectly) choose to be too conservative. After all, they’re risk averse to the mere word “aggressive.” They aren’t risk takers in any other area of life (relationships, business, skydiving or rollercoasters) but investing too conservatively at too young an age might actually be the riskiest thing of all (thanks to this thing called inflation). Given the choice of aggressive or conservative, some might choose conservative (having more money out of the market, sitting in cash and bonds), when given the choice of more risk or less risk, they would certainly choose less risk. But it is always less risky to act your age. An age-appropriate diversification helps us to act in an age-appropriate way, “forcing” some younger investors to be more aggressive than they might be otherwise, so that their money is growing at an acceptable rate.
Conversely, some older investors might (incorrectly) choose to be too aggressive, reasoning that it has worked for them over the decades to build wealth in riskier investment options. Maybe their personality is one that embraces risk, or perhaps years of success have given them a false sense of security, an overconfidence bred by wins remembered and losses forgotten. These investors almost need to be protected from themselves, and an age-appropriate diversification can provide the deceleration of risk as the time-horizon is shortened. This is important for pre-retirees in case the market drops just as they’re planning retirement, but it’s also important to their employer. After all, an aging workforce with (presumably) the largest balances in the plan provides a great risk to the employer, who wants to protect the nest eggs of those who stand to lose the most in an adverse market event.
So, Target Date Funds (the most common age-appropriate diversification tools used in retirement plans) provide assistance and even safety to both young investors and older investors.
So, what’s the current “State of the Union” when it comes to Target Date Funds (TDFs)?
The key to building wealth in a long-term retirement plan portfolio is to not take matters into your own hands and to not pay too much. Far too many investors are still self-directing. And far too many are paying too much for the professional management that they do receive. Both mistakes are indicators of a poor advisor.
Reasons that 401(k) investors self-direct
A Target Date Fund is designed to de-risk as a person gets closer to retirement (generally described as age 65). The portfolio reaches its lowest allocation towards stocks and its greatest allocation towards cash and bonds at the Equity Landing Point (essentially the equity-to-fixed-income ratio). A “To Retirement” strategy means that the investor reaches their equity landing point at age 65. A “Through Retirement” strategy means that the investor may not reach their equity landing point until well past age 65. Each strategy has its pros and cons, and its important that investors (and the companies that sponsor their plan) understand the differences.
“To Retirement” vs. “Through Retirement”
Not all TDFs are built the same
Not even all TDFs at the same TDF provider are built the same. There are 40 different TDF providers (as of the end of 2017) but there are 60 distinctly different TDF series among those 40 providers, meaning that the providers are using drastically different styles. One of the biggest differences is the use of passive or active management.
Passive management uses index funds, essentially tracking with the market benchmark, while active management is designed to beat the index or beat the market. Generally speaking, active management underperforms passive management the majority of the time, but in those years when active management outperforms the market it often outperforms it by a considerable margin. The active management costs more, of course, but the additional cost may be worthwhile if the returns in those high performing years is substantial.
Some TDFs are constructed from passive index funds, and they are very low cost. Other TDFs are constructed from active mutual funds, and while they may have higher overall returns they often have much higher cost. But more recently a third blended type of TDF strategy has developed that’s a type of hybrid model. The blended strategy uses passive investing with certain asset classes (like large cap US equity) while utilizing active investing with asset classes that yield higher returns for those higher fees. These blended TDFs are the fastest growing segment among the TDF solutions.
Bottom line … what should you do with all of this information?
BIG Mistakes employers need to avoid with TDFs