The Fatal Flaw in Your Retirement Plan's Target Date Funds

There was a major development in 2006 that transformed how Americans invest for retirement. It solved one problem, but created another that will be causing extra pain to people who retire in this economy.

The mid-2000s was the start of the nudge revolution, where policy makers thought they could coax people into more desirable behavior. The idea seemed especially promising when it came to saving for retirement, where research showed that automatically enrolling people in retirement accounts would increase saving and lead to better investment decisions.

So in 2006 the new Pension Protection Act allowed employers to enroll their workers by default into a 401(k) account or similar pension plan. Most plans placed people in target date funds, or TDFs, which were based on the premise that as you age, you should adjust your portfolio to lower risk. Accordingly, TDFs invest young people in stocks and gradually move them into bonds as they approach retirement.

More than 15 years later, the evidence is in on how well this is working. A group of economists studied the portfolios of plan participants from 2006 to 2018. On at least one level, the nudge was a success. The economists found that defaulting workers into TDFs increased stock ownership and participation in retirement plans.

‘A Major Weakness’

But TDFs have a major weakness, and their adoption also introduced a new risk to retirees that is just starting to be felt in the current high-inflation environment.

Target date funds are still very popular: $3.27 trillion of assets were invested in them as of the end of 2021. Prior to 2006, if you joined a plan and didn’t pick funds yourself, your savings were invested in a money-market account equivalent to cash, which many people never changed.

TDFs are more aggressive. If you are 25-plus years away from retirement, TDFs will invest you almost entirely in the stock market. This strategy increased wealth for many Americans because the last 15 years were very good for the stock market.

The study also found that Americans tend to move into bonds as they age, as TDFs are designed to do. This wasn’t the case before 2006, when portfolio allocations didn’t change much with age.

‘Fallacy of Time Diversification’

TDFs are a good strategy while you are in the saving phase of your life. But they have a crucial weakness that stems from what financial economists call the fallacy of time diversification, or the flawed idea that the longer you invest in markets, the less risky they are.

The logic follows that if you are closer to retirement, stocks are riskier because you have fewer years ahead to reap gains or recover from losses. Therefore, you should reduce your market exposure.

If you read the prospectus of most popular TDFs, the funds claim that their objective is to provide income in retirement, but this isn’t how the funds are invested. The funds move savers into shorter-term bonds — the duration is usually about five years around the age of retirement and it shortens further during retirement.

This is a reasonable strategy if the goal is to avoid losing money in the markets. But it’s not a useful strategy when it comes to spending your money in retirement.

Bonds & Inflation

I agree it makes sense to invest more in bonds as you age. There is a subtle but important distinction, though, when it comes to what type of bonds — and TDFs are invested in the wrong kind. The theory behind life-cycle investing isn’t that you must reduce risk as you age, it’s about gauging future earnings potential.