The next time target date funds (TDFs) suffer large losses, Baby Boomers won’t care that risk was rewarded until it wasn’t. They’ll be angry that academic theory was not followed because the theory would have protected them. After all, TDFs say they follow the theory, but they don’t—they’re much riskier. 78 million Boomers are currently in the “Risk Zone.” Many are in TDFs.
Academic Lifetime Investing Theory
Last year 401(k)Specialist published my Theory vs. Practice in Target Date Fund Glidepaths that contrasts the academic theory of lifetime asset allocation to current TDF practice. The academic theory was published in 2007, the year after the Pension Protection Act of 2006 established TDFs as a Qualified Default Investment Alternative. The 2007 article calls for an 80% risk-free investment near retirement. That’s the theory that TDFs say they follow. It combines human capital with investment capital as follows.
But actual TDF practice is much riskier at the target date—it’s more than 85% risky rather than 80% risk-free. And a new CFA Institute study using rigorous mathematics confirms the disconnect. TDFs are not following the theory they say they follow. They’re lying.
This creates excessive risk that will harm Baby Boomers the most in the next stock market crash. Boomers will—and should—be angry, so they will get revenge. You don’t want to mess with 78 million Baby Boomers who own more than half of all wealth in the U.S.
New CFA Institute Research Foundation Study
Enter a brand new study, released in a February 2024 CFA Institute Research Foundation paper: Idzorek and Kaplan: Lifetime Financial Advice, 2/15/24. Its 226 pages are loaded with sophisticated math that goes into great detail on lifetime asset allocations and related topics like taxes, utility curves and risk preferences. It’s very rigorous and comprehensive.
The following shows glidepaths for “Isabela,” who has a somewhat low risk tolerance.
Like the 2007 report, this new 2024 research advocates low risk for those near retirement, with less than 30% in equities. But most TDFs are not following this recommendation for a variety of reasons, although they say they follow the theory.
Why Lie?
Profits and procedural prudence are the motives for deviating from theory. High risk sells plus it pays more. Laurence Siegel, director of research at the CFA Institute Research Foundation, observes that, “After risky assets have gone up for a long time, risk sells.” After 15 years of rising stock prices, recency bias sets in, where stocks always go up.
Also the TDF oligopoly has made high risk the standard, so low risk has become the subject of lawsuits for underperformance. Fortunately, these lawsuits are not being won, but they’re expensive to defend, nonetheless. You can’t risk offering a low-risk product because equities have been king for the last 15 years—the longest bull market on record. High risk TDFs have been the winners for 15 years, the entire history of TDFs after 2009.
But surveys report that beneficiaries want low risk and most believe they are protected as they approach retirement. Substantive prudence—doing what is right and best—is not procedurally prudent currently, but that will change when this longest bull market ends.
There are a few substantively prudent TDFs that follow academic theory but they’re unpopular.
Two Types of TDFs: Safe and Risky
The industry has embraced the “To vs. Through” classification that was coined at the 2009 joint hearing of the SEC and DOL on TDFs, but this is a distinction without a difference because some “To” funds are riskier at their target date than “Through” funds. “Safe vs. Risky” is a much more meaningful classification as outlined in the following:
Most fiduciaries choose the Risky Group because it is procedurally prudent, with $3 trillion vs. just $300 billion in the Safe Group. The Risky Group is 10 times more popular, but that will change.
Fiduciaries Should Fear the Revenge of the Baby Boomers
My article on Revenge of the Baby Boomers has gone viral with more than 70,000 readers and 900 comments. Someday the stock market will correct. It always does and this time a correction is long overdue, plus the U.S. stock market is extremely expensive/overvalued on a variety of measures. Consequently, the next crash could be among the worst in magnitude and longevity.
Our 78 million Boomers are in what retirement experts call the “Risk Zone” when investment losses can spoil the rest of life. Many of these people are in target date funds and are extremely influential. Harm to Boomers should result in lawsuits for excessive risk, and—at the very least—repercussions for employers, where employees demand restitution.
Baby Boomers will get their revenge. Fiduciaries should be scared as heck. Safety in numbers won’t work. It didn’t work for excessive fees. As Warren Buffet said, “The next correction will reveal who has been swimming naked (unprotected).” Where there’s harm, there’s a foul.
Protection is More Important Than Performance for Retirement
TDFs readily acknowledge that they ignore Sequence of Return Risk (SORR), the documented fact that returns near retirement are the most important for retirement lifestyle because account balances are at their highest and paychecks have stopped.
Fund companies have explained their practice of ignoring SORR by saying risk has made you rich so you can afford some losses now. But the reality is that returns on your savings don’t matter much, especially as you approach retirement. Savings matter more than returns in the last 20 years of working life as shown in the following table from this article:
Most of the reason for whatever lifetime savings turn out to be is the amount of savings. Losing those savings as you near or enter retirement can jeopardize a retirement with dignity.
In other words, returns don’t matter much until we stop saving and begin spending those savings. Then the threat of losses matters a lot.
Conclusion
Academic investment theory is solid and has just recently been bolstered with rigorous new research. That’s why fund companies say they use it—it’s smart. But profits drive practice away from theory. Risk sells and pays more.
Someday—probably soon—beneficiaries will pay the ultimate price for deviating from theory. They’ll lose a substantial part of their lifetime savings. And they won’t care that high risk won until it didn’t. Losses will make them mad so they will get revenge. This time losses won’t be sloughed off as they were in 2008, because it’s different this time. TDFs are much more important today so the harm is much more painful.
Fiduciaries who have chosen risky TDFs should be very frightened because they may pay for their indiscretion. The fiduciary Duty of Care is like our responsibility to protect our young children from foreseeable harm. Beneficiary preference for safety near retirement has been ignored, implying an “I know better” philosophy that just doesn’t square with claims that academic theory is being followed. Theory gives beneficiaries what they want and need—safety near retirement.
Our economy is in serious trouble that threatens our securities markets. A stock market crash is imminent. It’s just a matter of “when,” not “if.”
SEE ALSO:
• There’s No Way Out. Deal With It.