Retirement Date

What's a Target Date Fund? Your Retirement's Best Friend

Retirement Date

Most days, 24 hours per day is just not enough time to get everything done. Ideally, every adult should be getting an average of 8 hour of sleep, 3 quality meals per day, try to keep it to 2 cups of coffee per day, plus 30 minutes of exercise, etc. etc. This equation doesn’t look the same for everybody, but for the most part covers the “ideal.” But that 8 hours of sleep quickly turns to 5 or 6, the exercise is non-existent, and we end up drinking more coffee than water throughout our day. Who has time for other things?

Don’t even bring up the topic of investing for retirement since most people are not only confused with the terminology associated with retirement plans, but retirement to most individuals seems so far away that it is not tangible or palpable. However, choosing to not think about investing for retirement, or really not finding the time to educate yourself, does not make it go away, and, more realistically, can create significant issues for individuals later on. We are no longer in the years of not having to think about saving for retirement since both public and private pension plans have become as existent as Blackberry cell phones, a few and far between.

Most people believe that they are on the right track to retire safely and securely by staying in a “Stable Value” Fund and contributing 3% per year to their 401(k). A recent article published by NAPA (National Association of Plan Advisors) showcased a study that surveyed 2,000 small business plan participants. The results were somewhat stunning:

  • 90% of respondents were somewhat satisfied with the investments available in their plan
  • 80% of respondents were somewhat to very reasonably satisfied with the fees in their plan
  • On average, plan participants want to replace 95% of their pre-retirement income, which is well above the 70-80% range that is the common recommendation from industry experts. You can find more information about research on replacement rates here, as we interview Marlena Lee from Dimensional Fund Advisors.
  • Only 50% of respondents were confident that they were on the right track to meet that targeted replacement income in retirement

Although survey respondents felt satisfied with their plan investment lineup and fees, the survey also stated “participants are famously disengaged—possibly owning to the lack of understanding of various aspects of their plan.”

  • 37% of participants did not take any action in their 401(k) plan, whether it be increasing their deferrals, making Roth contributions, enrolling in their 401(k), or stopped making contributions to their 401(k), etc.

We don’t expect plan participants to make any changes in any given year, but based off of experience, the results are more likely due to not being engaged in the process. As we mentioned in the beginning of this article, participants have enough to worry about in their day, but we must be able to find a solution that fits participants’ limited time availability.

Enter the Target-Date Fund!

The survey also mentioned that 50% of respondents haven’t heard or understood what target-date funds were. As a quick summary, target-date funds are a proprietary blend of different mutual funds that target different asset classes and automatically reduce the exposure to stocks and increase the exposure to bonds and cash over time, as to target the diminishing capacity of risk for those who are retiring in or around its stated “target-date.” So for example, Vanguard has their Target Retirement 2040 Fund (VFORX). It is meant to be a lower-cost diversified portfolio for someone who is planning to retire in the year 2040, so someone who is approximately 40 years old, give or take a few years. The current asset mix is 89% stock and 11% bonds, and will automatically increase the allocation to bonds overtime. If we looked at the Vanguard Target Retirement 2015 Fund (VTXVX) as a reference point to see what asset allocation someone is expecting to have at retirement, we can see the allocation is now 50% stocks and 50% bonds. Again, the investor does nothing, as the portfolio will automatically adjust for them.

At IFA, we are big believers in adopting a target-date fund approach for retirement plans for two big reasons. The first addresses the aforementioned issue of the time constraint placed upon participants. A passively managed target-date fund is the ultimate “set-it and forget-it” investment option. The second reason has to do with ongoing discussions with plan participants. By removing confusing investment lineups and simplifying the enrollment process, participants can focus on what really matters: saving! The dialogue transforms from “which is the best mutual fund?” to “am I on track to retire?” That latter question is the one that really matters.

But not all Target-Date Funds are the same. There has been a substantial increase in target-date fund offerings in the industry given their endorsement from the Department of Labor. Be careful! The same principles apply to a target-date fund as do any other type of mutual fund. Participants should choose funds that are passively managed, low-cost, and very well diversified.

IFA has also created a lineup of target-date index portfolios based off of our IFA Index Portfolios. Our goal was to bring a very automated investment lineup to the marketplace given what we have learned about the needs of plan participants. We have been offering a Glide Path strategy to clients outside of a 401k plan for several years, but have now had the ability to bring them to the retirement plan market given advances in technology on recordkeeping platforms. What is slightly different about our target-date index portfolios is the risk reduction plan, or the path at which the fund decreases its allocation to stocks and increases it allocation to bonds overtime. As you can see in the chart below, we follow a linear glidepath, or risk reduction program. We chose to go with a 1% per year decline in stock allocation because the exposure to risk will continually adjust as participant's risk capacity also slowly declines with age.

One of the great benefits of investing in passively managed, index fund target-date portfolios is the amount of data that is available to help with the planning process for plan participants. For example, the chart below gives some descriptive metrics on the IFA Target-Date Index Portfolio 2040. This portfolio is suitable for those who are between the ages of 40-44 and have approximately 24 years until retirement. The portfolio has a stock/bond mix of 74/26 and will have an ending stock/bond mix of 50/50 in 2040, or at the time of retirement for this particular set of participants. If we just looked at the last 24 years ending 12/31/2014, we can see that this portfolio had an annualized return of 8.92%. Not bad at all! An initial investment of $5,000 would have grown to just shy of $40,000. But investors wouldn't be comfortable about taking the most recent 24 year period and extrapolating it into the near future. Remember, it is just one 24 year period and no advisor should make decisions on just one data point. Fortunately, because we use index funds in our portfolios, we can look at 313 24 year rolling periods going all the way back to 1965 in order to be more confident in our future expectations. The median, or the exact middle of the range of outcomes, was approximately 12.09%. We always like to point to the worst case scenario so that investors are aware of the possible range of outcomes. As you can see, the lowest 24 year rolling period return between 1965 and 2014 was 7.92%, which isn't too far off from the 8.92% that we recently experienced. Another interesting data point is the 1 year rolling period return. The lowest return was -36.79%, so obviously this particular target-date fund would not be suitable for someone who was looking to retire within the next couple of years. You can click on the different portfolio buttons at the top of the chart to see the different metrics for the different target-date funds that IFA offers. 

IFA Target Date Index Portfolio Example

Given the limited amount of time participants have for everyday activities, adopting a lineup of target-date index portfolios can be a great long-term investment solution. Investors can shift their already limited availability to discussions about proper savings rate to make sure they are on the right track to retire. If you are interested in learning more about target-date index portfolios or IFA’s Retirement Plan Solutions, feel free to contact us at 888-643-3133.