As you evaluate your 401k or employer retirement plan's menu of investment options, you will very likely see a series of target date funds (TDF's) with a wide range of retirement dates. These funds are designed to automatically adjust the mix of stocks and bonds over time to become increasingly more conservative as the defined retirement date approaches. This kind of "auto pilot" feature can be very attractive to investors who do not feel comfortable with this portfolio management responsibility and can help them avoid being overly exposed to stocks at a stage of life where they don't have the capacity to accept the potential volatility.
Unlike index funds, where two funds that are tracking the same benchmark (i.e. S&P 500) will by definition have the same portfolio composition, not all TDF's (even those with the same retirement date) are created equally. Each fund manager (i.e. Fidelity, T Rowe Price, Vanguard) has discretion on the glide path for the fund. Which leads us to question #1.
1) What exactly is the glide path?
The glide path is originally an aviation term for a plane's course from cruising to safe landing. In the investing world it is the rate at which the allocation of the portfolio is adjusted over time as the designated retirement date approaches. As the image below indicates, if an investor is 40 years from their target retirement date, this hypothetical portfolio would be invested 95/5, with the 95% being in stocks. As you move from left to right and the number of years to retirement decreases, notice how the portfolio allocation shifts to progressively more bonds or fixed income. Plotting this out over time creates visual of the glide path.
Prior to the introduction of TDF's, it was up to the investor or their financial planner to monitor and reallocate their portfolio over time. While TDF's are a good case of financial innovation which can simplify the experience and perhaps improve the results, it's still important to spend some time up front to understand how each fund is setup so you select the option on the menu which aligns with your goals and risk tolerance. With your personal finances, even if you leverage an automation feature like auto pay on your credit card, this doesn't absolve you from the responsibility of reviewing your statement for unfamiliar charges and to have awareness of your spending habits. The same can be said for TDF's. Leverage the benefits of automation, but understand what's going on under the hood.
2) What differentiates one glide path from another?
There are two primary types of glide paths that are used within TDF's:
1) Those that go "to" retirement: This strategy reaches a steady state allocation at the start of retirement and maintains this mix going forward.
2) Those that go "through" retirement: This strategy continues to adjust the allocation beyond the start of retirement, in some cases not reaching steady state until 10+ years after the fund's defined start of retirement.
Click HERE to see an example of a Vanguard Target Retirement Fund (2045: VTIVX). Notice that the glide path goes "through" retirement and reaches a steady state allocation 7 years into retirement (2052).
In terms of which of these two primary strategies is better, like almost all personal finance questions, the answer begins with "Well that depends on....". Each investor has their own goals, life expectancy, risk tolerance, and unique factors so there is no "one size fits all" portfolio allocation that will work for everyone at age 65 or any age for that matter.
I personally favor TDF's that continue to adjust the allocation beyond the start of retirement. A static asset allocation for a period of time that could easily span 20-30 years is taking the notion of "set it and forget it" way too far for my liking. Holding a constant asset allocation from age 25 to 50 doesn't make much sense to me and the same can be said for age 65 to 90. Retirement is a journey, not a destination.
3) How do I know what the TDF's glide path looks like or if it goes to or through retirement?
In the Vanguard example cited above, they graphically present the glide path front and center on the summary page of the fund. Each company will do this a little differently. If you don't see the glide path in the summary, review either the prospectus or the fund fact sheet and they will present graphically or verbally discuss the fund's philosophy as it relates to the glide path and investment allocation. Click HERE and scroll to "Principal Investment Strategies" for a Fidelity example (also a 2045 fund) where the glide path is presented in the summary prospectus.
4) What do I do if the TDF with my planned retirement year has an asset allocation that is too aggressive or conservative for me?
Let's say you are 30 years from when you expect to retire. In most cases, the menu of options will have funds in five year intervals (2020, 2025, 2030, etc.). You would initially select the 2050 TDF as the closest match to your target retirement. Upon reviewing the current allocation, you might see that the fund is 90/10 (stocks/bonds). If this high allocation to stocks would cause you to lose sleep at night or to login and view your account balance every day, your best course of action is probably to start with the 2045 and walk forward until you find the fund that has a current asset allocation that you are comfortable with. Depending on who is managing your Plan, you might have to move 2-3 funds forward (retirement date 10-15 years earlier) until you reach the allocation that feels "right". The Vanguard TDF cited above holds a constant allocation until 25 years to retirement date and then begins the glide path that gradually reduces the exposure to stocks.
5) Based on #4 above, I am now looking at a TDF with a retirement date nowhere close to reality for me. Should I be concerned?
In my opinion, you have to find your comfort zone as it relates to the risk you're taking on in your portfolio. Selecting the fund that matches your retirement year won't feel like a good choice if the higher volatility causes you to do something irrational like move everything to a money market fund during a market downturn. The glide path won't even matter if the turbulence causes you to grab the parachute and bail out!
The other side of the coin is you need to be aware that when you reduce the risk in your portfolio, you have also simultaneously reduced the long-term expected return. There is no free lunch in investing....or in life. Reconciling where you should be on the risk/reward continuum is an area where a financial advisor can really add value. They can run scenarios using both the 90/10 and the 75/25 allocations and show you the impact on the projected balance of your nest egg. You can then decide what changes you will make to your financial plan (retire later, increase your savings rate) to offset the impact of a more conservative portfolio allocation.
He or she will likely also counsel you that volatility is par for the course and when your retirement is 20+ years down the road, you have more than enough time for the market cycle to correct itself. A short-term decline or even a nagging bear market won't have a material impact on the success of your retirement plan IF you resist the urge to sell at the bottom of the market.
If you are unsure how 'on track' you are toward your ideal retirement or you're stressed over the many decisions you are facing along the way (i.e. which target date fund should I choose?), contact me to schedule a complimentary consultation.