A Target-Date Fund’s Hidden Risk

Target-date mutual funds have hidden risk and may not work as well as intended.

The funds are preprogrammed to increase their bond allocation as the shareholder ages. For example if you plan on retiring in 2040 then you might be interested in buying a target-date fund with a 2040 date on it. The theory is that as a person becomes older they need to increase their allocation into bonds to reduce risk. For example, the idealistic goal for a 2040 fund is by 2040 the fund manager has sold off a significant portion of the risky stocks and put mostly (allegedly) low risk bonds in the portfolio. However because bond prices are very high then the hidden risk is that as the economy returns to normal interest rates will go up causing bond prices to go down. This will hurt the bond component of the portfolio, which may surprise investors since they may have assumed that bonds have less risk than stocks.

The best way to handle retirement nest egg risk is to manually pick investments based on the unique circumstances and facts. Currently there is unique new program of Quantitative Easing run by the Federal Reserve since 2009 which has created huge distortions in bond and stock prices. Thus the old clichés about investments don’t apply during these treacherous times, so one must use active management in selecting bond allocations.

The target-date fund might decide for a young person’s target-date fund that bonds should be in long term Treasuries but a long term bond with high duration is vulnerable to loss of value if interest rates increase. The correct way to handle the bond allocation would be to invest in low duration bonds. “Duration” means how long is the wait to get your money back, so a 10 year bond might have a seven year duration because the coupon payments mean that on average you got your money back in seven years even though the principal was paid back in ten years. Once the economy returns to normal then long term bonds could be bought at lower prices and the fund manager should then buy a balanced mix of long term and intermediate term bonds for the bond component of the portfolio, while maintaining some diversification in stocks.

The fallacy of the target-date fund is that people may mistakenly assume that they can buy it and forget about it. There is no such thing as a magic “one-decision” investment where you buy it and forget about it. Investments need to be monitored for new paradigm shifts that are similar to the disruption or creative destruction of new technology that destroys old technology firms.

About the author

Don Martin, CFP®

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