Steve Doorn has been featured in the Crain’s Grand Rapids Business Wealth Management Guide for his article on; Why Target Date Strategies Miss The Mark.
Check out the full Wealth Management Guide Here: https://www.crainsgrandrapids.com/wealth-management-guide-2024/
The saying “if it seems too good to be true, it probably is” could easily apply to target date strategies. Take something that’s extremely complicated (retirement planning) and develop a simple and easy-to-use solution (target date strategies) that is suitable for everyone (default option in most 401k plans). Who wouldn’t want that? Unfortunately for most Americans, that’s not the right approach. Their retirement savings investment strategy shouldn’t be reduced to making a single decision such as picking the year in which you think you’ll retire. Simple, yes. Effective, not so much.
The concept of the target date strategies makes sense to many investors, especially those who are just starting to save for retirement. With so many investment options to choose from in a typical company-sponsored plan, it can be overwhelming to know which ones are right for you. The target date strategy offers a single choice that is diversified and automatically manages the mix of investments over time. Aggressive for younger investors just starting out and becoming more conservative for those closer to retirement age. But is that the best solution?
According to Morningstar, $3.5 trillion was invested in target date strategies at the end of 2023. This is a $2.6 trillion increase in the past 10 years. Much of this growth can be traced back to the Pension Protection Act of 2006 which contained provisions that allowed employers to automatically enroll their employees in the company-sponsored retirement plan.
Under ERISA guidelines, target date strategies are considered qualified default investment alternatives. When an employee is automatically enrolled but doesn’t make an investment election, the default is likely a target date strategy. Vanguard, which manages the largest amount of target date strategy assets ($1.3T), estimates that 83% of participants in the plans it manages have invested in a target date strategy.
So why should you consider an alternative approach? Target date strategies have three main faults. First, they only consider one factor: the time horizon. Second, the investment options within each target date strategy are limited. Third, their asset allocation changes aren’t dynamic based on changing market and economic conditions.
A successful retirement doesn’t happen by chance, but rather through careful planning.
While the investment time horizon is important, it’s only one factor that should be considered when developing an investment strategy. Other things to consider are liquidity needs, risk tolerance, other assets and investments, longevity, and taxation. Accurately choosing a retirement date when you’re in your mid-20s, and first starting to save for retirement, is almost impossible. What if you end up working longer or shorter than you originally expected? What if you receive an inheritance in the future? How long is your retirement going to last? What happens if you switch jobs? The target date strategy may end up being too aggressive or too conservative, significantly altering the quality of your retirement.
Most retirement plan sponsors have a fiduciary responsibility to the plan participants which requires them to offer a broad array of high-quality, low-cost investment options. Target date strategies on the other hand often have investment options that are limited, both in terms of investment choices and manager. For example, the Vanguard Target Retirement 2035 Fund is limited to investments in five of Vanguard’s mutual funds.
Company-sponsored plans often have investments across several asset classes, from stocks and bonds to commodities and real estate. Target-date strategy portfolios are often comprised of just stocks and bonds. Most plans also offer both passive and active investment options, often from a variety of high-quality asset managers which allow the employee to create a portfolio that’s unique to their situation. The ability to customize the portfolio allows the participant to incorporate several other important factors into their decision-making.
One of the main attractions of target date strategies is the automatic shift from an aggressive investment approach to one that’s more conservative over time. Each target date strategy has a “glide path” that adjusts the asset allocation of the portfolio based on the number of years to retirement. The typical target date strategy begins to gradually reduce the equity allocation around 30 years before retirement with the pace accelerating around 15 years prior and continuing up until retirement. Ultimately the stock allocation drops from 90%+ in the early years to around 35% at retirement. With people living longer, longevity risk is a real concern. By only considering the time horizon when determining the asset allocation, target date strategies fail to adjust to changing market conditions.
While we would never advocate for investors to try to time the market by making short-term changes to their investment allocation, we do recognize that there are times when making tactical adjustments can result in better outcomes. An investor who reduces their stock allocation during or after a bear market is likely selling low (stocks) and buying high (bonds). Conversely, continuing to increase one’s stock allocation after several years of appreciation may result in a portfolio with too much risk. Having a well-defined strategy based on one’s unique situation can avoid both of these pitfalls.
Investing in target date strategies also assumes everyone who has plans to retire in or near the year specified has the same investment objectives, risk tolerance and similar personal circumstances. The truth is that everyone’s situation approaching and during retirement is different. Doesn’t it make more sense to invest accordingly?
A successful retirement doesn’t happen by chance, but rather through careful planning. This requires developing and adhering to an investment strategy that is as unique as you are. Using a cookie-cutter approach, such as target date strategies, that are based largely on ease of implementation and ongoing management, can be fraught with mistakes. Unfortunately, the problems are usually only recognized long after there is anything that can be done to correct them. Working with an experienced team of investment, financial planning, tax and estate professionals who can help design a customized wealth strategy will not only reduce the stress of retirement savings but also increase the odds that your retirement will be on target.
Legacy Trust is an independent, locally owned, Michigan-chartered bank that specializes in providing investment and wealth management services to individuals, families, foundations and non-profits in West Michigan. Legacy Trust delivers highly customized financial and investment solutions tailored to meet the unique situation of each client. For more information, visit www.legacygr.com.
Steve Doorn, CFA
Senior Vice President,
Chief Investment Officer