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Aging Badly

Mike Zaccardi

AMID THIS YEAR’S market wreckage, perhaps the most disappointing performers have been target-date retirement funds (TDFs).

Many 401(k) investors are familiar with these products. Just one of these funds can be used throughout your investment lifetime, as it automatically shifts from a stock-heavy portfolio in the decades leading up to the targeted retirement date to owning more bonds in the years immediately before and after the target year. Normally, performance is pretty steady for TDFs close to their target date, thanks to their high bond allocation.

Not this year. The 10-year Treasury yield has nearly doubled since the start of 2022, leading to massive bond market losses. Remember, higher yields mean lower bond prices. The rate surge has also driven down stocks, as the value of future profits is discounted even more steeply. That’s meant a double-whammy for folks in balanced mutual funds and TDFs.

TDFs came about in the early 2000s, but they have never seen a year like 2022, with both global stocks and bonds falling sharply. Vanguard Group’s TDFs are down between 10% and 15% in 2022. What about the past 12 months? Whether you look at the relatively low-risk Vanguard Target Retirement Income Fund (symbol: VTINX) or the most aggressively invested Target Retirement 2065 Fund (VLXVX), losses are uniformly around 6%.

Is it time to ditch your TDF? No way. If you’re like me—in your accumulation years—a TDF within your 401(k) or IRA continues to make sense so long as its annual expense ratio is under, say, 0.1% per year. What about those nearing or in retirement? You might consider tailoring your investment strategy, rather than sticking with an off-the-shelf target-date fund.

Why? Retirement expert Michael Kitces argues that the most risk-sensitive period is the initial retirement years. This is when your portfolio is likely at its largest and thus a large market downturn can have the biggest dollar impact, potentially derailing the rest of your retirement. After that, a more aggressive portfolio could be warranted. Moreover, a large retirement account balance could benefit from going with lower-cost individual index funds rather than owning a single TDF.

Another tip: In a regular taxable account, it’s better to hold plain stock index funds or, better yet, exchange-traded funds than TDFs. Many folks found this out the hard way while filing taxes this year. In late 2021, Vanguard’s TDFs paid out huge distributions that were taxable to those holding a TDF in a taxable account. That meant a hefty capital gains tax bill.

Faced with lousy returns from both stocks and bonds, this isn’t the time to abandon your long-term investing glide path toward retirement. But it might be a good opportunity to check you have the right funds in the proper account type. If that means selling a TDF in a taxable account, you’ll find your realized capital gain is smaller thanks to 2022’s market swoon—and perhaps you’ll even harvest losses that trim your 2022 tax bill.

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Cammer Michael
Cammer Michael
4 months ago

I don’t understand how bond funds are considered a safe investment when rates are low. They don’t provide significant interest and their value will inevitably drop.

UofODuck
UofODuck
4 months ago

I agree that TDF’s are a good investment tool in preparation for retirement – in a tax deferred account using a fund with low fees. Many employer sponsored plans offer TDF’s, but few employees are aware of the fund fees they are paying. You also need to pay attention to the asset allocation of one dated fund versus another. Employees will typically choose the fund with a date closest to their anticipated retirement date. As the fund approaches its nominal “maturity” date, it will typically reduce its risk exposure. This is an old school approach to managing risk as we approach retirement and does not take into account that our life expectancy post-retirement could easily be 10, 20, 30 or more years. And, if the retirement fund balance is rolled into an IRA at retirement, the life span of the fund could be much longer if children receive an inherited IRA. Bonds and cash are not likely to generate sufficient income in retirement and most retirement portfolios should have a reasonable amount of equity exposure to ensure an adequate level of total return.

Ormode
Ormode
4 months ago

If stocks are sky-high because interest rates are at rock bottom, it doesn’t take an economics wizard to see what might happen when interest rates rise. I’m surprised so many people bought into these funds.

Philip Stein
Philip Stein
4 months ago
Reply to  Ormode

If people avoided these funds because stocks were high, wouldn’t they be market timing? And if they shunned TDFs, what alternatives should they have chosen?

Should people put their retirement savings on hold because the market is high? If you’re investing for a long-term goal, the current state of the market should be irrelevant.

TDFs remain a good choice for folks saving for retirement but who don’t want to manage a multi-fund portfolio by themselves. Reinvesting dividends and making periodic investments when the market is down boosts your expected future return. Sounds good to me.

Mike Zaccardi
Mike Zaccardi
4 months ago
Reply to  Ormode

I heard the same thing in 2011

Rick Connor
Rick Connor
4 months ago

Thanks Mike, great info as always. Thanks for the Kitces reference – I look forward to reading it. I’ve been thinking about the sequence of returns risk in conjunction with a SS claiming decision. I generally think delaying SS to 70 makes sense if you have the assets to support your lifestyle as a bridge to SS. However, if you are spending assets in a declining market that is worrisome. I guess the cash bucket is the best answer, allowing your equities to ride out the storm.

Mike Zaccardi
Mike Zaccardi
4 months ago
Reply to  Rick Connor

You can always do some Roth conversions in a down market before taking SS. Especially with many folks’ marginal tax rate inching up from 22% back to 25% in 2026.

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