Target-date risks
Criticism of target-date funds is heating up in the aftermath of hearings by the SEC and the Department of Labor. But rather than illuminating the retirement investing problem, the discussion has only highlighted a yawning deficit in the public debate.
The first criticism of target-date funds is that they are too risky, particularly the 2010 funds for those approaching retirement, which fell sharply in the 2008–2009 market meltdown. Policymakers and commentators complain that the risks were too large. The Federal Thrift Savings Plan for federal employees is sometimes held up as a better model for the private sector. It had a 2010 fund that declined by a small amount.
This criticism of target-date funds is centered on short-term risk—and highlights a high level of risk-aversion among critics, as well as perhaps a lack of understanding about longer-term risks. The marketplace, however, is taking a different view. Most money managers begin with the view that older Americans have a sizeable portion of their wealth in an inflation-adjusted government-guaranteed annuity: Social Security. They must look at risk holistically, not just as the short-term market risk of a 401(k) account or IRA.
Moreover, it is well known that inflation risk and longevity risks loom large in retirement. One of the major costs in retirement, health care, has been soaring ahead of incomes for decades. Out-of-pocket health care costs are expected to surge even faster as Congress addresses the struggling finances of Medicare. The risk of inflation is substantial, especially with large federal deficits. Longevity continues to creep up slowly. In such an environment, retirement savings invested principally in Treasury bonds (yielding 3.5% today) or bank CDs (<1%–2%) won’t last long.
No money manager dedicated to the fiduciary protection of investors considers it wise to focus only on short-term market risk, especially for employees approaching retirement. The long-term risks are too grave. (In fact, from this perspective, the Federal Thrift Savings Plan seems too cautious. If there is one group that can take more investment risk, it is federal employees—with steady employment, above-average wages, and taxpayer-guaranteed pensions.)
A second criticism of target-date funds is that 401(k) investors don’t understand them. Here the lack of perspective is breathtaking. For several decades, the criticism leveled at 401(k) plans (and other forms of self-directed investing) has been that many Americans lack the skills to make informed choices and create a professional portfolio. Some of our own research at Vanguard has highlighted the problem. Now, with the introduction of target-date funds, inexperienced investors have a simple way to select a professionally managed portfolio that can be based on the year they expect to retire. They are better able to avoid important errors, such as investing too cautiously or too aggressively.
And yet—it is reported as news that such individuals don’t understand the portfolios constructed for them! It is circular reasoning all around. Target-date funds were designed precisely for individuals who don’t know what they’re doing.
A third criticism is that fund companies have crammed junky products into 401(k) plans. Under the law, however, the decision to add target-date funds to a retirement plan is first and foremost the employer’s decision. These employer decisions are governed by what is recognized to be one of the most comprehensive standards of fiduciary conduct—the Employee Retirement Income Security Act of 1974. In carrying out their ERISA fiduciary duties, employers in the marketplace today are making careful assessments of products, benefits, and risks for their 401(k) plans. They are a critical lynchpin in the system—and their fiduciary oversight role is too often downplayed.
Finally, there’s the trend to paint all target-date funds with the same brush—that they are all high-cost or poorly managed or too aggressive. Yet four out of every five dollars in target-date funds are managed by three of the world’s leading money managers (yes, including us at Vanguard)*. All of these managers have similar portfolios risks and allocations, and all three have exceptional reputations as investment managers. (By the way, so do many of the companies running the rest of the money.) Yes, there are some junky target-date funds. But headlines like “Most target-date funds well managed” won’t sell papers.
The real risk of target-date investing, of course, is not that asset values declined in 2008–09. In policy and media circles, focusing solely on such declines is a major investment error (just as it is for individuals investing their own savings). Rather, the real risk is that unsophisticated investors at retirement age will be persuaded by an imperfect public debate that their only recourse in retirement is to hold safe investments. In ten and twenty years, only then will the true risks of that advice become apparent.
For more on target-date investing, see the Washington, D.C., testimony of my Vanguard colleague and fellow blogger John Ameriks.
* Source: Strategic Insight.
Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund’s name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a target-date fund is not guaranteed at any time, including on or after the target date.
Notes:
- All investments are subject to risk. Investments in target date funds are subject to the risks of their underlying funds. Investments in bonds are subject to interest rate, credit, and inflation risk.
- Past performance is no guarantee of future returns.
- Bank deposit accounts and CDs are guaranteed (within limits) as to principal and interest by the Federal Deposit Insurance Corporation, which is an agency of the federal government.
- The link to NYTimes.com will open a new browser window. Vanguard accepts no responsibility for content on third-party websites.
If target-date funds were designed precisely for individuals who don’t know what they’re doing and they are still misunderstood, perhaps the product is not well designed. A close reading of the problem indicates individuals tend to purchase by the title of the fund. That may seem crazy but it pretty much goes hand in hand with current financial literacy. Rather than using target dates in the fund titles, perhaps a universal risk indicator could be established and reflected in the titles. But the final solution for the individual may be simply to take more out of their check for social security and let them live with the results. Why restrict social security to a government mandated percentage. Why not let folks contribute as much as they want so they can bypass 401k decisions and all the rest of the investing mess they seem to wade into.
Being more conservative than a 2010 fund in light of the bubbles and volatility of the past 20 years is no vice.
I am amazed that your target date funds have much higher equity allocations than your founder John Bogle recommended, always holding your age in bonds. You cranked up the equity allocations to match your competition in 2006, just in time for the markets to fall in 2008.
Also, why no admiral shares of the target funds, and no international small cap exposure? All the sub-funds have admiral shares available, and your new VFSVX fund would be a good fit for a small percentage of allocation for greater diversification.
It’s too bad the public isn’t better informed re the appropriate TR fund for the investor’s needs and risk level.
Very unhelpful article. The author said nothing about the risk of a high equity allocation in 2010 TR funds. What does he think is an appropriate allocation for equities for those in retirement?
“A second criticism of target-date funds is that 401(k) investors don’t understand them.”
Another reason they should teach about personal finances in high school, if this is true!
A fourth criticism should be the high stock allocation of most target-date funds, including Vanguard. The traditional rule of thumb used to be “age in bonds.” No less an authority than Jack Bogle still espouses it.
But around the Great Bull Market of the 1990s stock allocations started to increase.
Target Retirement 2010 is currently allocated at less than 50% bonds–15 years more aggressive than “age in bonds.” I’ve never seen a convincing justification for this. It’s said that “people are living longer,” but in fact the life expectancy of 65-year-olds has only been increasing at the rate of about one year per decade. Lifespan increases would justify lowering bond allocation no more than 3% below the traditional recommendation, not 15%.
Worse yet, we are expected to commit to these funds for a lifetime, yet the funds themselves do not stay the course, but yaw all over. Why did Vanguard juice up its stock allocations in 2006? Research? Theory? Analysis? Or competition for Morningstar ratings?
It’s all well to speak of “a high level of risk-aversion among critics,” but the what matters is the risk aversion of PLAN PARTICIPANTS. I say participants are being cajoled, lured, and defaulted into allocations exceeding their risk tolerance. And I say that order of returns is important, and losing 30% of your portfolio just as you hit retirement is no joke, and can’t easily be made up later.
Risk is a very hard thing for investors to fathom. Those at or near retirement are typically only concerned about losing money short-term. As long as TR funds were going up in value, you didn’t hear any complaints about them.
On “safe investments,” do you have Professors Kotlikoff and Bodie in mind? If so, kindly take on their views directly. Both gentlemen have launched serious critiques to target date retirement funds.
The past 15 years have eroded my trust in equities and the current financial debacle has left me with a very low opinion of bankers and hedge funds.
As for your 20 year horizon, it is reasonably probable that equities will not live up to your expectations.
“In ten and twenty years, only then will the true risks of that advice become apparent.”
Yes, but only because someone will measure growth from the bottom of the 2008-09 decline. It is hard for me to imagine that a 60% equity-portfolio will do as well from 2006 to 2019 as a 30% equity portfolio over the same period. But no one will show us those numbers.
Interesting arguments, well reasoned, well written. Digging in further, I’m curious to know how the author would support his contention that, “Most target-date funds well managed; a few need a reality check,” which he offers as the boring headline no newspaper would write but as his take on reality.
That may or may not be true. But it would be interesting to see what evidence he’s using to come to that conclusion.
Thanks.
Steve,
Overall, I think you have raised some interesting viewpoints for critics, laypersons, and law-makers alike, specifically about the concepts of loss-aversion and the lack of understanding about long-term risks.
You state: “This criticism of target-date funds is centered on short-term risk—and highlights a high level of risk-aversion among critics, as well as perhaps a lack of understanding about longer-term risks.”
Simply, what can Vanguard, which offers the some of the most-qualified perspectives in the Investment world, currently do to help not only investors better understand loss-aversion and long-term risk better but also do to take the “national cacophony” of this time within this “hundred year flood” in our national and global economies and make what Vanguard does even better?
Dialectic logic proposes that our thesis (perspective) will always create an anthithesis (opposite perspective), which with intellectual rigor and brainstorming comes synthesis (a fuller perspective). How will Vanguard look upon this time to better an already well-grounded premise of Target date funds?
Thanks…the blogs have added a needed perspective to Vanguard’s committment to have an educated and informed investor.
Well stated. The problem with target date funds is the idea that one size fits all. However, if you are not a skilled tailor, achieving the average is not bad!
Steve,
Vanguard erred when they bumped up the stock portion of the TR funds a few years ago. It was obviously done to compete with Fidelity which had a higher stock allocation at the time. Also, while Federal employees MAY have the ability to take more investment risk they MAY not have the need to take more risk for the reasons you gave. This is an important distinction that you glossed over.
Hey good stuff…keep up the good work! I read a lot of blogs on a daily basis and for the most part, people lack substance but, I just wanted to make a quick comment to say I’m glad I found your blog. Thanks,)
A definite great read…
There is obviously a lot to know about this. There are some good points here.
the problem with target date funds isn’t lack of knowledge it’s over confidence in the markets. 2010 funds should have been more conservative than they were. we’re told in the prospectus that they asset allocation becomes more conservative the closer you get to the target retirement date. unfortunately, they asset allocation did not become conservative enough. since most people don’t retire with pensions, many people will begin withdrawing from their 401k at retirement. once you start withdrawing you should have no tolerance for risk unless you have more than you need. if you have just enough to last you need to dramatically reduce your exposure to risk. many of these funds did not do that. some however did much better than others.