Beware: Target Date Funds Ignore Sequence of Return Risk

• Sequence of Return Risk (SORR) is a very well-documented threat to retirement with dignity.
• Target date funds (TDFs)ignore SORR, so they’ve recently suffered severe investment losses for those near retirement.
• There are a few Safe TDFs. There should be more.

Recent stock and bond losses have brought attention to “Sequence of Return Risk” (SORR). Retirement savers near retirement in target date funds (TDFs) have lost 17.6% this year through September 30. These people might not have enough time left to recover from such losses since paychecks have stopped. That’s the nature of SORR.

Losses sustained in the “Risk Zone” spanning the 5-10 years before and after retirement can spoil the remainder of life.

SORR is ignored

TDF fund companies ignore this risk because, as reported in  this article :

“The reason for the failure of the financial services industry to tackle sequence risk, he says, comes down to the simplest issue: money. “Most of the industry isn’t compensated for managing that risk,” Jamie Hopkins (Carson Group) says. “In the grand scheme of the industry, it’s not worth it.”

TDFs are designed for profit. Fees for managing risky assets are higher than fees for safe assets like cash.

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.

Losses matter most in the Risk Zone

Whatever we’ve saved as we near retirement has to be “enough” because that’s all there is. We make plans to make “enough” last a lifetime. Investment losses change those plans and can increase reliance on a society that wants to help its elderly. However, be aware that Social Security and Medicare/Medicaid are on the brink of failure – they’re running out of money.

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.

SORR is not new but forgotten

The 13 years following the 2008 meltdown have set record-breaking highs. The “Roaring 2010s” brought a 600% stock market rise while bond prices doubled. No SORR has existed for a long time, but that just changed.

Just as the Roaring 20s brought the Great Depression, the Roaring 2010s has brought us the “Depressing 2020s.” For more insights on what lies ahead, please read The Rest of the Story.

The last time SORR mattered was 2008, when TDFs for those near retirement lost more than 30%, prompting a public uproar that has since been forgotten. Although forgotten, SORR did not go away because here it is again.

A few TDFs manage SORR

There has been a bifurcation between Risky and Safe TDFs, as shown in the following allocations at the target date:

Most TDFs are about 85% risky at the target date, with 50-55% in equities and 30-40% in risky long-term bonds. By contrast, some TDFs are Safe, with less than 30% in risky assets, including:

• The Federal Thrift Savings Plan (TSP), the largest savings plan in the world
• The Office and Professional Employees International Union (OPEIU), one of the largest AFL-CIO unions
• The SMART Target Date Fund Index, A normative index for safe TDFs

The following performance contrast demonstrates the difference between recent Risky and Safe TDF performance:

Safe TDFs are defending in 2022 with a loss of only 5% versus the Risky group’s 17.6% loss.

Conclusion: Will TDFs change?            

TDFs did not change following the 2008 crisis. They became riskier. So why would they change now? Because there’s much more at stake, as shown in the following:

This importance, and concern about risk, have led to a Congressional inquiry. And this time, unlike in 2008, there could be lawsuits for ignoring SORR, a very well-documented threat to retirement with dignity.

Stay tuned.

Ron Surz is President of Target Date Solutions, a DBA of PPCA inc. He is also the author of Baby Boomer Investing in the Perilous Decade of the 2020s. He can be reached at Ron@TargetDateSolutions.com.