Individual Investors Build Superior Target Date Portfolios
- The biggest shortcoming in target date funds (TDFs) is that they are one-size-fits-all.
- Individual investors should manage their own unique target date portfolios (TDPs) tailored to their needs and circumstances because no mutual fund TDF can do so
- Most individual investors will need a financial advisor to guide them through their personalized TDP glidepath. It’s a lifetime plan that is far superior to any TDF.
Millions of investors in TDFs are bonded together on a ride to who knows where, trusting their employers and hanging on the hope that there’s safety in numbers.
Despite their incredible popularity, having grown from nothing to $2 trillion in just the past decade, target date funds (TDFs) have a serious flaw: they are one-size-fits-all. Institutional investors who are trying to solve this problem have come to realize that the only cure is to personalize glidepaths to each individual, but this is not practical for entire workforces in 401(k) plans. Consequently, millions of 401(k) participants in TDFs are bonded together on a ride to who knows where, trusting their employers and hanging on the hope that there’s safety in numbers.
Individual investors have an edge over institutional investors. They can use certain aspects of TDFs, like glidepaths, and customize them to their unique needs and circumstances, and they can do so for a very reasonable cost. Individual investors can build their own customized target date portfolios (TDPs).
Target date portfolios are far better than target date funds
We all have our individual needs and circumstances that drive our investment decisions. We are different from those in any one-size-fits-all TDF in the following ways:
- Risk tolerance
- Circumstances like wealth, health and family
This is where financial planning can help. A “good” adviser can guide an investor to appropriate investment decisions through time using a personalized target date portfolio (TDP).
The TDF model is helpful for this guidance... The key to a comfortable retirement is to (1) save enough, and (2) keep it. TDFs have elements of this discipline that can be improved upon by individual investors who manage a customized TDP. A wise investor will protect his/her lifetime of savings in the Risk Zone that spans the transition from working life to retirement. A generic TDP glidepath is shown as the red line in the following picture:
A successful TDP is the result of 3 disciplines:
- Saving enough and spending wisely in retirement
- Making wise risk decisions. This can be distilled down to the “Three Decision Points” discussed below.
- Using a good financial advisor
Saving Enough and Spending Wisely
Much has been written about how much needs to be saved for a comfortable retirement, and how a spending budget can help savings last a lifetime in retirement. There is general agreement that we need to start saving early in life and to try to save 15% of pay each year. Similarly, the “4% Rule” is a popular spending rule in retirement that spends 4% of savings in the first year, and then increases that amount by inflation in each subsequent year. Of course, these rules are typically broken as life events make them hard to follow, but they serve as good guidelines.
Importantly you should develop an investment plan that helps savings last a lifetime, as discussed in the next section.
Three Decision Points
A TDF template is helpful to formulating your TDP risk decisions. As shown in the following graph, there are 3 critical decision points along a glidepath: (A) Risk when you’re young, (B or B’) Risk when you enter retirement, and (C) Risk in retirement. The graph uses equity allocation as the measure of risk. “Equities” should be broadly diversified and include global stocks, real estate and alternatives like commodities.
Decisions about points (A) and (C) – beginning and end of the glide path – can begin by considering somewhere around 100% to start and 45% to end. Point B is the most critical point because it marks the middle of the “Risk Zone” that spans the 5 years before and after retirement. Losses in the Risk Zone can severely reduce lifestyle in retirement because account balances are at their highest level. Most mutual fund TDFs are 55% in equities at the target date, point B. This allocation lost more than 30% in 2008, and the next market correction could be even worse. We recommend the safe point B’, or about 10% in equities, in order to protect savings in the Risk Zone.
These are the key decisions to discuss with your financial advisor
Using a Good financial Advisor
A TDF is like flying on a commercial aircraft: you’re going where everybody else is going with a bunch of strangers. By contrast, a TDP is like your own private jet, going where you want to go. You’ll need a good pilot to get you there safely.
You could implement your personalized Target Date Portfolio on your own, but you should consider employing a financial advisor for help. If you do, you’ll want to choose the best.