This should be an uncomplicated decision. Figure out when you reach age 65 or so, and then you can forget all about the nitty-gritty backbone of investing. It's easy to kick back and allow your fund to act on your behalf, self-correcting as it sees fit. Guide you through all of the vicissitudes of a deranged market. This is all a fantasy though. Regardless, retirement target funds are anyway gaining wide popularity (from zero to >$700 billion all within a decade), particularly among younger workers. And as markets have risen, there has not yet been the opportunity to see who has been swimming naked until the tide goes out; it might very well be you. Assuming anyway that you go this route for your savings, does it even matter which fund company you use? Are there any additional risks that you should be mindful of?
In this article we show that given any specific target date, risk allocations vary enormously among the major fund companies. We see that one should be deliberate in how they consider dollar-cost averaging with these funds. And one should examine what is their own psychological tolerance, for the eventual market pains that persistently ensue. Not simply knowing a mathematical level for risk capacity, but something that allows one to sleep well at night, during recurring market corrections (here, here, here). The bottom line is exploring these target funds is very much not so easy. Let's start by seeing what the cash allocation is across the major funds, and we also include the allocation from the government's savings plan (extended to U.S. federal employees), which by the way has a lavish minimal payout for our low-return environment.
We notice that the 3 major companies (Vanguard, Fidelity, T. Rowe Price) each have tiny cash allocations (if at all) across one's entire working career. Even when it's best for your 401(k) for example, these companies don't earn profits from getting you into cash, and it shows with the graphic above. The government savings plan, on the other hand, has a considerable cash allocation (nearly 1/3 of the fund weight within a decade of retirement). Vanguard and T. Rowe Price each have a low cash level for people retiring in 2040, for say a current 40 year-old who is 25 years from retirement. Furthermore, these cash allocations surprisingly, just diminish further as one approaches retirement!
Let's now take a peek at the stock allocations for these same funds. Before we further analyze the implications of what we are seeing. Notice first that the right-hand side, vertical axis, which is different in the illustration below.
What we see is a different pattern from the top most chart above. Just above, T. Rowe Price's allocation has a lot more resemblance to the lower allocation of the government savings plan, at least up until the most important, half-decade prior to one's retirement. Fidelity, in contrast, keeps its high stock allocation for a lengthier period into one's life. They have a nearly 85% allocation in their 2030 fund, for those retiring in 15 years. Equally perturbing, Fidelity has an undeterred >50% allocation for those retiring today! Good luck with these options.
The summary, from all of what we see above, is that the risk laden in retirement target funds is exceptionally high. In the case of Vanguard and Fidelity particularly, the risk allocation never really tamps down as you approach retirement. This was a caution also raised by the Securities and Exchange Commission in a speech. There is also risk, to be sure, inherent in the bond allocations of any of these funds. It's not all just in stocks.
Simply look at the returns below, for 20 days during the August 2015 tumult we just experienced. We trace the returns for two different 2015 retirement funds: the high-stock allocation Fidelity fund versus the low-stock allocation T. Rowe Price. One would think ex ante that having the lower stock allocation of T. Rowe Price would have led to a smoother ride during the market rout; but that is false. Not only did both funds experience the same fright, but both absurdly have investors in this high-risk 2015 fund, who inopportunely are just about to retire!
We could now reverse our analysis. And suggest that if the risks appear the same shouldn't it be, say, better to aim for the higher stock allocation (say for Fidelity) - in order to extract greater upside potential? The answer is unmistakably no. Since the risk-adjusted returns from both stocks and bonds make the bond mix in the portfolio more than worthwhile. Contrast the performance of the two funds above, from a broader horizon, starting in 2008:
Period Fidelity T. Rowe Price
2008 -32% -30%
2009 29% 31%
2010 13% 14%
2011 -1% 0%
2012 12% 14%
2013 13% 15%
2014 5% 5%
YTD -3% -3%
T. Rowe Price has a much better investment and risk profile, through a portfolio that has a respectable blend of both stocks and bonds. To be sure, Fidelity is not terribly worse than T. Rowe Price (if you consider that an endorsement). Particularly in the past couple years, as we see in the top chart above that Fidelity ramps up its cash position, appropriately as one begins to retire.
So let's see what happens when we take two hypothetical 60 year-olds (named Fidel, and Troy) at the end of 2007, and each has $1 million of retirement money. Fidel plows his money into Fidelity's 2015 fund, and Troy has his money in the T. Rowe Price 2015 fund. Today, Fidel would now have $1.3 million. Not a bad way to capture the stock market upside, since 2007. But Troy even with a smaller stock allocation weight would have $1.4 million! The simple choice of picking the fund company behind your retirement target fund had freely yielded a $100 thousand difference (after 8 years and per $1 million investment.)
Now there is also the question of one's temperament. Having a high stock allocation, similar to Fidelity, could be good over one's broader career, if they were psychologically comfortable with the inevitably large downturns in the markets. These funds as well will go down considerably, and the August/September chart above is a mere sample of the drama, which can unfold as you look the other way. Would you stay aligned and add more investment on a regular basis during a market slump? Or would you run for cover at large market drops and simply seek shelter in something safer - until the markets have recovered? If it's the latter, then it would be unwise to be in such a gigantic risk allocation (even if Vanguard for the moment inherently persuades you otherwise). The theory here is that your behavior will force you to miss out on the most advantageous price moves in the fund, fully negating the catalyst for being in such a high risk fund to begin with.
A thoughtful discussion of what is the optimal risk level one should take, as they approach retirement, is provided through our Abnormal Risks article. This article was shared by a board member of Lending Club (another board member by the way -Larry Summers- kindly told me that he enjoyed my previous article concerning Harvard's "poor returns".) Workers of all ages should always note any deep differences they have in their allocation versus this optimal view of risk, from the Abnormal Risks article, in addition to the overall longevity risks that overhangs one's thoughts during retirement (here, here, here).
A final point concerning target funds is that one can still partially rebalance for optimization, by spreading out their invested savings over time. Say partitioning their paycheck into 10 daily purchases, instead of all on payday. See the risk below for example, if one has a straight 60/40 fund that was never rebalanced for two years [making the assumption that both have the same standard deviation (σ) and no correlation between the two assets].
Variance
= 2*60%^2*σ^2 + 2*40%^2*σ^2
= 1.04*σ^2
Now let's do that again for the 60/40 fund, except have the fund rebalanced at the end of the first year.
In this article we show that given any specific target date, risk allocations vary enormously among the major fund companies. We see that one should be deliberate in how they consider dollar-cost averaging with these funds. And one should examine what is their own psychological tolerance, for the eventual market pains that persistently ensue. Not simply knowing a mathematical level for risk capacity, but something that allows one to sleep well at night, during recurring market corrections (here, here, here). The bottom line is exploring these target funds is very much not so easy. Let's start by seeing what the cash allocation is across the major funds, and we also include the allocation from the government's savings plan (extended to U.S. federal employees), which by the way has a lavish minimal payout for our low-return environment.
We notice that the 3 major companies (Vanguard, Fidelity, T. Rowe Price) each have tiny cash allocations (if at all) across one's entire working career. Even when it's best for your 401(k) for example, these companies don't earn profits from getting you into cash, and it shows with the graphic above. The government savings plan, on the other hand, has a considerable cash allocation (nearly 1/3 of the fund weight within a decade of retirement). Vanguard and T. Rowe Price each have a low cash level for people retiring in 2040, for say a current 40 year-old who is 25 years from retirement. Furthermore, these cash allocations surprisingly, just diminish further as one approaches retirement!
Let's now take a peek at the stock allocations for these same funds. Before we further analyze the implications of what we are seeing. Notice first that the right-hand side, vertical axis, which is different in the illustration below.
What we see is a different pattern from the top most chart above. Just above, T. Rowe Price's allocation has a lot more resemblance to the lower allocation of the government savings plan, at least up until the most important, half-decade prior to one's retirement. Fidelity, in contrast, keeps its high stock allocation for a lengthier period into one's life. They have a nearly 85% allocation in their 2030 fund, for those retiring in 15 years. Equally perturbing, Fidelity has an undeterred >50% allocation for those retiring today! Good luck with these options.
The summary, from all of what we see above, is that the risk laden in retirement target funds is exceptionally high. In the case of Vanguard and Fidelity particularly, the risk allocation never really tamps down as you approach retirement. This was a caution also raised by the Securities and Exchange Commission in a speech. There is also risk, to be sure, inherent in the bond allocations of any of these funds. It's not all just in stocks.
Simply look at the returns below, for 20 days during the August 2015 tumult we just experienced. We trace the returns for two different 2015 retirement funds: the high-stock allocation Fidelity fund versus the low-stock allocation T. Rowe Price. One would think ex ante that having the lower stock allocation of T. Rowe Price would have led to a smoother ride during the market rout; but that is false. Not only did both funds experience the same fright, but both absurdly have investors in this high-risk 2015 fund, who inopportunely are just about to retire!
We could now reverse our analysis. And suggest that if the risks appear the same shouldn't it be, say, better to aim for the higher stock allocation (say for Fidelity) - in order to extract greater upside potential? The answer is unmistakably no. Since the risk-adjusted returns from both stocks and bonds make the bond mix in the portfolio more than worthwhile. Contrast the performance of the two funds above, from a broader horizon, starting in 2008:
Period Fidelity T. Rowe Price
2008 -32% -30%
2009 29% 31%
2010 13% 14%
2011 -1% 0%
2012 12% 14%
2013 13% 15%
2014 5% 5%
YTD -3% -3%
T. Rowe Price has a much better investment and risk profile, through a portfolio that has a respectable blend of both stocks and bonds. To be sure, Fidelity is not terribly worse than T. Rowe Price (if you consider that an endorsement). Particularly in the past couple years, as we see in the top chart above that Fidelity ramps up its cash position, appropriately as one begins to retire.
So let's see what happens when we take two hypothetical 60 year-olds (named Fidel, and Troy) at the end of 2007, and each has $1 million of retirement money. Fidel plows his money into Fidelity's 2015 fund, and Troy has his money in the T. Rowe Price 2015 fund. Today, Fidel would now have $1.3 million. Not a bad way to capture the stock market upside, since 2007. But Troy even with a smaller stock allocation weight would have $1.4 million! The simple choice of picking the fund company behind your retirement target fund had freely yielded a $100 thousand difference (after 8 years and per $1 million investment.)
Now there is also the question of one's temperament. Having a high stock allocation, similar to Fidelity, could be good over one's broader career, if they were psychologically comfortable with the inevitably large downturns in the markets. These funds as well will go down considerably, and the August/September chart above is a mere sample of the drama, which can unfold as you look the other way. Would you stay aligned and add more investment on a regular basis during a market slump? Or would you run for cover at large market drops and simply seek shelter in something safer - until the markets have recovered? If it's the latter, then it would be unwise to be in such a gigantic risk allocation (even if Vanguard for the moment inherently persuades you otherwise). The theory here is that your behavior will force you to miss out on the most advantageous price moves in the fund, fully negating the catalyst for being in such a high risk fund to begin with.
A thoughtful discussion of what is the optimal risk level one should take, as they approach retirement, is provided through our Abnormal Risks article. This article was shared by a board member of Lending Club (another board member by the way -Larry Summers- kindly told me that he enjoyed my previous article concerning Harvard's "poor returns".) Workers of all ages should always note any deep differences they have in their allocation versus this optimal view of risk, from the Abnormal Risks article, in addition to the overall longevity risks that overhangs one's thoughts during retirement (here, here, here).
A final point concerning target funds is that one can still partially rebalance for optimization, by spreading out their invested savings over time. Say partitioning their paycheck into 10 daily purchases, instead of all on payday. See the risk below for example, if one has a straight 60/40 fund that was never rebalanced for two years [making the assumption that both have the same standard deviation (σ) and no correlation between the two assets].
Variance
= 2*60%^2*σ^2 + 2*40%^2*σ^2
= 1.04*σ^2
Now let's do that again for the 60/40 fund, except have the fund rebalanced at the end of the first year.
Variance
= Variance 1st year + Variance 2nd year
= [60%^2*σ^2 + 40%^2*σ^2] + (<1)*[60%^2*σ^2 + 40%^2*σ^2]
= [60%^2*σ^2 + 40%^2*σ^2] + (<1)*[60%^2*σ^2 + 40%^2*σ^2]
< 1.04*σ^2
Extrapolating from this insight, we see that a more frequent rebalancing would allow for a high compression in variance (not to zero but still optimally lower). Now retirement target funds don't rebalance daily (generally quarterly). And thus the up and down trends (mostly "up" in recent years) just builds momentum during the quarter until these funds' next rebalance. Imagine how much you would be missing during a longer-term bear market, where you see 20% declines on the major indexes (complete with many 3% or so down days).
Instead we offer here in this article that you instead can slightly guide your own trail, by chopping up your bi-monthly pay into 10, and buying 1/10 into your retirement fund each business day between paychecks. You can best take advantage of the sizable short-term pullbacks in the markets, similar to what was seen on China's Black Monday (August 24). To further document this response, let's see what the result would be for two other hypothetical people (each with $1 million also on August 18, but now in a 60/40 total stock and total bond fund). On September 16, the one with a non-rebalanced fund would have $972 thousand. While the person capable of daily rebalancing their 60/40 stock/bond exposures would be worth 0.1% greater ($1 thousand greater in just 20 days). This portion is inline with the type of high annual fees of high-fee mutual funds (which happens to be the subject of my future article published next month by the CFA).
So stay alert and remain vigilant with the abundant considerations we outline here. As you enjoy both the risks and the rewards of these newly innovative, target date funds!
Instead we offer here in this article that you instead can slightly guide your own trail, by chopping up your bi-monthly pay into 10, and buying 1/10 into your retirement fund each business day between paychecks. You can best take advantage of the sizable short-term pullbacks in the markets, similar to what was seen on China's Black Monday (August 24). To further document this response, let's see what the result would be for two other hypothetical people (each with $1 million also on August 18, but now in a 60/40 total stock and total bond fund). On September 16, the one with a non-rebalanced fund would have $972 thousand. While the person capable of daily rebalancing their 60/40 stock/bond exposures would be worth 0.1% greater ($1 thousand greater in just 20 days). This portion is inline with the type of high annual fees of high-fee mutual funds (which happens to be the subject of my future article published next month by the CFA).
So stay alert and remain vigilant with the abundant considerations we outline here. As you enjoy both the risks and the rewards of these newly innovative, target date funds!
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