There are serious disconnects between reality and participant perceptions of target date fund (TDF) risk. Surveys report that most TDF participants are confident that TDFs will bring them to their retirement goals, and that they think they are protected against investment losses. These views might be reasonable for young participants, but the reality is far more perilous than these perceptions for older participants.
Optimism is no surprise in light of the great performance of TDF over the past 18 years because TDFs have had only one losing year, in 2022. The last time TDFs suffered a serious loss was way back in 2008 when they lost more than 30%.
But nothing has changed since 2008. In fact, TDFs are riskier today because equity allocations have increased as providers strive to win the performance race. In other words, a repeat of 2008—or worse—is a real possibility. If participants actually look at the allocations of their TDFs near retirement they will see that they are not nearly as protected as they think they are, and that sequence of return risk could rob them of a retirement with dignity.
At the 2009 hearings of the SEC and DOL on target date fund losses, fund companies testified that participants should have understood the risks. They didn’t understand then, and they still don’t understand now. Favorable perceptions of TDF risk reflect faith in the fiduciaries who choose them. Fiduciaries should understand, but do they? Procedural prudence is currently not substantive prudence.
Let’s take a close look at TDF risk exposures for people near retirement in the Retirement Risk Zone.
Asset Allocations Near Retirement
I recently discussed the potential consequences of high TDF risk in Confidence in Target Date Funds is a Mistake Waiting to Happen, in which I explain that “Most of our 75 million Baby Boomers are in their Retirement Risk Zone. There’s $5 trillion at stake in TDFs, so another 30% loss like 2008 would be $1.5 Trillion (with a T). The Retirement Risk Zone is the 5 years before and after retirement during which Sequence of Return Risk peaks, meaning that losses can devastate the rest of life.”
A repeat of 2008 would be devastating. Are TDFs actually protecting those near retirement? Should participants in TDFs be confident?
In What Baby Boomers Need to Know About Target Date Funds, and Why, I show the following asset allocations at the target date.
Most TDFs are not safe near their target date. They are 85% risky, which might be okay for young people, but not for those near retirement because they will not recover from a serious crash, and their heirs will feel it too.
Current Likelihood of a Crash
The stock market is currently very expensive, with a P/E of 40. If it normalizes toward its historic average of 15, it will lose more than 50% regardless of earnings growth, much worse than 2008.
Here are the ranges of returns that could be earned over the next year based on earnings growth and ending P/E. On the positive side, if P/Es remain above 30, the stock market will deliver a positive return.
Which do you think will happen—regression toward the mean or continuation of expensiveness? Current capital market indicators are signaling regression toward the mean:
Conclusion
Survey results reveal confidence and optimism in TDFs for understandable reasons, but the perception is far from the reality. TDF participants have been very lucky over the past 18 years. This luck might continue for a while longer, but we know one thing for sure: the stock market will crash someday, and when it does people near retirement in TDFs will not be protected—that’s the reality.
EDITOR’S NOTE: This column has been edited to include an inadvertently missing section.