Target-date funds, or what some call TDFs, have become the investment of choice for many folks saving for retirement. You buy one fund that is aligned with your anticipated year of retirement and you don’t have to do much else.
But one expert says TDFs, while good on paper, fall short of being the ideal retirement savings vehicle. Yes, TDFs make sense for 401(k) plan participants who might otherwise invest too much in their company or stock too much in low-yielding stable value funds. And such funds do provide plenty of diversification.
“The idea behind the target-date fund was, you got people to put their portfolios together which were very diversified and then ostensibly as they got closer to retirement, the portfolio would have less equity risk and more bond risk, thereby giving some ability to preserve the capital,” Arun Muralidhar, the chairman and founder of Mcube Investment Technologies and the chairman and chief investment Officer of AlphaEngine Global Investment Solutions, said in a recent interview. “So conceptually, they are good.”
The challenge Muralidhar has with TDFs though is this: “A lot of people assume that you put your money in the target-date fund, and you’re done. And you don’t have to think about retirement ever again. And the sad part is a target-date fund guarantees neither of retirement wealth amount, nor a retirement income amount. So when you have a product that gives highly variable outcomes to people, are investors in target-date funds taking a massive risk that they don’t understand? And so my concern is we need to improve the quality of the product, not necessarily sort of rip it apart and throw it out.”
Muralidhar says another danger associated with TDFs is this: “They don’t disclose the risks as appropriately as I would want. This product has safe harbor status, which means nobody has any recourse if they get a bad outcome. The moment you set it up that way, where there’s zero recourse to the investor if they end up retiring poor, the standard of disclosure of risk needs to be a lot higher in my opinion.”
So, it’s not a bad product,”it’s just that for a very small audience it may be the perfect product,” he said. “I’m guessing for the large majority it’s the wrong product.”
So what’s needed instead? What sort of investment product would work better for those saving for retirement. Well, it’s something called target-income funds or TIFs. Those are funds that would provide investors with a specified level of income in retirement — much like a defined benefit plan or an annuity.
In today’s retirement planning world, savers know how much income they can expect to receive from Social Security and, if they have one, their defined-benefit plan. But that’s not the case with a 401(k) plan which only tells the investor much money they’ve accumulated, and not how much income those assets will produce.
(Muralidhar is also fond of Bonds for Financial Security (BFFS) and Standard-of-Living-indexed Forward-starting Income-only Securities or (SeLFIES), but those products don’t exist in reality yet either. Read more from TheStreet on new ways to save.)
So, when planning for retirement, where you want a steady stream of cash flow stream through retirement, TDFs — which invest in stocks and bonds — are risky from that retirement-income perspective, according to Muralidhar, who spoke recently at the Investments & Wealth Institute’s annual conference.
A target-income fund, by contrast, would ask the investor: “What is your desired level of target income?” So the investor gets to specify their goal, said Muralidhar. “They also get to specify how much they’re willing to save, when they plan to retire, and the amount of risk they’re willing to take,” he said.
The TIFs would also provide investors with a feedback loop. “I think that feedback loop is critical to helping people understand that as they’re approaching retirement, either they’ve achieved the level that they need and therefore they don’t need to take more risks or, well, they’re not tracking as they had hoped, they need to take some corrective actions,” said Muralidhar.
“I think that’s where this new brand of product, which solicits input from the investor is critical as opposed to a target date fund where the assumption is you’re done once you make that selection,” he said.
In the absence of TIFs being a reality, however, Muralidhar doesn’t advise against investing in target-date funds. “I would say be aware of what to buy,” he says. “It’s buyer-beware because what’s happening in the target-date fund is it’s rotating out of stocks into bonds just because you grew one year older.”
Muralidhar is also a proponent of telling investors how much income the assets in their 401(k) will produce. “Rather than telling people in the 401(k) statement, ‘You’ve saved $100,000,'” he said. “Maybe it’s better to tell them, ‘You’re going to be able to earn $5,000 a year for 20 years.’ That may shock them into thinking that this large amount of money that they’ve accumulated may not support the lifestyle they want.”
People have this wealth delusion that they think they’ve got a lot of wealth accumulated. “Telling them how much it translates to into retirement income could have a very different implication for how they behave,” said Muralidhar, who recently published The F-Utility of Wealth: It’s All Relative.