Out of Sequence: Why TDF Risk Near Retirement is a Bad Bet

I’ve said that target-date fund (TDF) risk is too high at the target date. I’ll now explain why.

“Some say fiduciaries don’t know or care about TDF risk. That will change. Let the lessons begin.”

Retirement researchers have documented the importance of Sequence-of-Returns Risk and the Risk Zone. Losses sustained in the five to 10 years before and after retirement can do irreparable harm. It’s a gauntlet we each must run once.

But target-date funds do not protect against this risk, ending 85% in risky assets at their target retirement date – 50% in equities plus 35% in risky long-term bonds. They are gambling on good returns in the Risk Zone that will enhance life.  

Some say the gamble should be even bigger, criticizing TDFs for being too conservative, but 2008 proves otherwise. 2010 Fund TDFs lost more than 30% in 2008.

In A Different Perspective on Sequence-of-Returns Risk T. Rowe Price justifies high risk by showing high returns needed to compensate for inadequate savings and longevity.

The T. Rowe Price argument misses some crucial facts:

• Risk doesn’t make you rich. Savings make you rich and are independent of the TDF.
• Risk might help you get richer but protecting your savings is the better choice when paychecks are about to stop. Without paychecks, recovery from loss is much more challenging.
• Beneficiaries report that they want to be protected as they near retirement. They don’t want to gamble.

Does a Good Sequence Lie Ahead?

Sequence-of-returns cuts both ways. A loss in the Risk Zone undermines lifestyle, but a gain enhances lifestyle. That’s where “risk” comes into play. The higher the risk, the greater the range on both the upside and the downside.

An investor who is in the Risk Zone can decide if (s)he feels lucky or not, but a beneficiary in a TDF has surrendered that decision to a one-size-fits-all glidepath. Most assets in TDFs are from defaulted beneficiaries.

High risk at the target date is a gamble on a good return sequence, on good luck. It’s a gamble that surveys say beneficiaries don’t want to make. The good news is that this gamble has paid off in the past decade, although not preferred by beneficiaries. But that will change. It always does.

Retirees of the past decade have made it through the Risk Zone unscathed and happy. Will future retirees be so lucky? Seventy-eight million baby boomers will spend much of this decade in the Risk Zone. Thankfully, they were not in the Risk Zone in 2008.

Savings are more important than returns

Savings make you rich. Returns on those savings help too. Both the savings rate and investment return matter. The following table produced by Professor Craig Israelsen shows that savings play a critical role as we age. The older we get, the more essential savings become and returns become less critical because there’s less time for them to compound.

Most of us don’t save much when we’re young. Saving early is smart but uncommon. Retirement starts to become real as we age. As the table shows, our savings rate is the critical factor at the time that most of us begin saving for retirement later in life. Glidepath returns matter less until we stop saving at the target date.

As savings end and we move from working life to retirement, protecting those savings is critical to the retirement lifestyle. Most do not want to gamble on good luck at this stage.

Risk might help you become rich as you accumulate wealth but protecting wealth at its peak keeps you rich.

Beneficiaries can’t eat rates of return

TDF beneficiaries do not earn the returns reported by fund companies. Fund companies report what is known as time-weighted returns, but beneficiaries earn dollar-weighted returns, the correct measure of wealth accumulation.

Time-weighted returns eliminate the effects of savings, so they are the same for all beneficiaries. By contrast, each beneficiary has a unique dollar-weighted return that reflects individual savings. There are as many dollar-weighted returns as there are beneficiaries.

It’s complicated. Performance reports do not capture this nuance. From a plan perspective, encouraging savings is a good thing. Keeping those savings is also important.

The level of savings matters more than returns on those savings.

Dollar-weighted versus time-weighted returns

The performance evaluation industry has debated for decades about which rate of return is the most appropriate. The dollar-weighted, AKA money-weighted, return measures the return on wealth, placing heavy weight on the timing and amounts of contributions:   

RD dollar-weighted return is the rate that equates cumulative contributions to current wealth  

 V = ∑Ci(1+RD)Ti where V = current wealth Ci = contributions Ti = time from contribution to today

Dr. David Spaulding has long advocated for money-weighted returns because they convey the joint success or failure of the investor with the success or failure of the investment manager.

But investment managers usually have no control over contributions, so the performance evaluation industry uses time-weighted returns that eliminate the effects of contributions:

RT Time-weighted return compounds the returns between contributions 

RT = π(1+ri), where the RI are rates of return in between contributions

In other words, the investor cares most about his dollar-weighted return because it is a measure of success or failure in building wealth. The investment manager wants a level playing field where (s)he is not held responsible for contributions. 

The amounts and timing of contributions are the primary determinants of wealth. Returns matter, but not that much, especially when savings start later in life.

No control

TDFs have no control over beneficiary savings, so each beneficiary has a unique dollar-weighted rate of return, a return that is savings specific to the beneficiary. Each beneficiary is responsible for his/her current wealth because each is responsible for savings.

So, blanket statements about TDF beneficiary wealth are unsubstantiated. Each enters the Risk Zone with an individual account balance. Some will have made substantial contributions at beneficial times, and some will not, but all must face the Risk Zone.

The appeal of a glidepath is that it moves the beneficiary toward safety as retirement nears, but my opinion is that TDFs remain too risky at the target date. They are failing their primary mission to protect.

Conclusion

The prescription for retiring with dignity is simple: (1) save enough and (2) don’t lose those savings. “Save and protect” is a good mantra for retirement. That’s my opinion, and I’m sticking to it. Risking lifetime savings in the Risk Zone is a bad gamble, even if it has paid off over the past decade.

The TDF industry is taking a lot of risk for those near retirement. The wisdom of that bet is changing. Interest rates are going up, and stock market bubbles are bursting. We will see a repeat of the 2008 disastrous losses, and this time it will be worse because bonds no longer defend and TDFs are now $3.5 trillion versus $200 billion in 2008.

There are a few TDFs that defend at the target date. The most notable is the $800 billion Federal Thrift Savings Plan (TSP). It is 70% safe at the target date in the government-guaranteed G fund. Another example is the Office and Professional Employees International Union (OPEIU).

There are two distinct TDF designs with materially different objectives.

Some say fiduciaries don’t know or care about TDF risk. That will change. Let the lessons begin.

Ronald  Surz is co-host of the Baby Boomer Investing Show, and president of Target Date Solutions and Age Sage, Target Date Solutions serves institutional investors, namely 401(k) plans. Age Sage serves do-it-yourself individual investors.

His passion is helping his fellow baby boomers at this critical time in their lives when they are relying on their lifetime savings to support a retirement with dignity, so he wrote a book, Baby Boomer Investing in the Perilous 2020s, and he provides a financial educational curriculum.