A: Bob this is a great question that I hope I can shed some important light on the associate risk of target-date funds. However, before I jump too far ahead, let me provide a basic explanation for my readers. Target date funds are a type of mutual fund designed to simplify retirement investing. Investing in a single target-date fund is like buying into a fully diversified retirement portfolio that evolves with your needs as you age. The name is deliberate: Target-date funds are designed to target your anticipated retirement date.
In my opinion, Bob, target dates funds are one of the worst products ever created by the financial industry. Driven by an industry focused on 5-star ratings, these funds are often a collection of a fund management company’s worst performers and re-branded under a new manager as a Target-anytime fund to retain assets. What I am saying is that fund companies often launch a herd of new funds giving a number of investment managers the opportunity to okay.
I am often asked, “Do target date funds actually reduce the risks that an investor faces as they get older? Today, bond investors are exposed to tremendous risk if inflation picks up and interest rates rise. Target date funds that move the asset allocation from stocks into bonds are exposing older investors to this risk. Furthermore, the more money that is in bonds, the less diversified is the portfolio. A portfolio that is heavily invested in bonds is not necessarily safer, even in the short run than a more diversified portfolio. Because we have had low inflation for the last 30 years, in my opinion, investors have gotten complacent. Just as the run-up in real estate prices from 1995-2005 lulled many mortgage lenders into thinking that real estate wasn’t very risky, the long bull market in bonds has lulled investors into thinking that bonds are safer than they really are.
High inflation, which will be very bad for long-term bonds, might be a “Black Swan” event—something that doesn’t happen very often but could happen. High inflation happened in the 1970s and killed bond returns. 2008’s stock market decline of -37% was a Black Swan event. Most people are not well-prepared for Black Swan events.
So, how can one get a safer portfolio that reduces the exposure to the risks of stocks and the risks of long-term bonds as one age? One way is to shorten the maturity of the bonds. The other way is to invest in bonds that provide protection against inflation. Such bonds exist. They are issued by the U.S. government and are called Treasury Inflation-Protected Securities (TIPS). The coupons and principal amounts are automatically adjusted upwards whenever the Consumer Price Index (CPI) increases. A target date fund that invests in TIPS thus reduces the inflation risk that the portfolio is exposed to.
Unfortunately, almost all target date funds do not include TIPS as part of their bond investments. The best alternative, although far from perfect, appears to be Vanguard’s target date funds. Instead of moving all of the money from stocks into bonds, their target date funds move some of the money into U.S. Treasury Inflation-Protected Securities (TIPS) beginning when most of the investors near retirement age. A discussion of Vanguard’s logic is available at this link. Vanguard target date funds also have the advantage of lower fees than most target date funds charge: an average of only 17 basis points per year.
The bottom line is that target date funds don’t necessarily reduce the risk that an investor is exposed to as one gets older. Most target date funds still leave an investor exposed to, and may even increase the exposure to, the risk of a bond market collapse associated with high inflation. Investing in a target date fund that includes TIPS as part of the bond portfolio would be a wise idea. Don’t assume that the fund managers always have your goals in mind based on a number or date in the future that might coincide with an important event in your life.
