Only Stocks for The Long Run? Why Target Date Funds Suck
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Target Date Funds have become the go to solution for many 401ks with nearly 4tln using these approaches. The idea sounds great - pick your retirement date and let the fund manage the diversification and risk in your portfolio so you have a well managed nest egg ready for retirement. But what many investors are learning this year is that these are badly constructed portfolios that amount to a concentrated bet on stocks, even for those very close to retirement. 2022 has delivered a shocking drawdown for many, and if we see a further equity market decline caused by the looming recession, those close to retirement will be left with far less than they expected.
Even relatively modest adjustments to increase diversification like holding longer duration bonds, allocating to commodities, and increasing allocations to cash earlier in the cycle could both maintain expected returns but also reduce the risk that retirees are left with much less than they expected close to retirement. The time to adjust these portfolios is now before we see the next round of equity declines.
This year many investors received a large shock when stocks fell substantially and their ‘diversified’ and ‘risk-adjusted’ funds fell nearly as much as the stock market did. Through September the global stock market ($VT) fell 25%. The vast majority of target date funds fell 20%. Part of that was the bonds fell at the same time stocks fell. But most of these funds hold very small portions in bonds, so even if they did better it really wouldn't have helped. And this doesn’t even include the drag in purchasing power from inflation running in the high single digits as well.
Most of these funds have very high allocations to equities ranging from 56% in the 2025 fund to ~85%+ in the 2045 and beyond funds. Since the stock allocations are roughly 2.5x more volatile than the bond allocations, stocks drive an even more meaningful portion of the experienced return (as you can see in 2022 above). The result is on a risk basis all of these funds are basically just driven by equity performance over the short-term.
These funds are essentially one big bet on stocks for the long run. Stocks, and particularly US stocks, have been one of the best asset classes in terms of returns over the last century. But even with the US unique outperformance, stocks in real terms have experienced lengthy and substantial real return drawdowns. Drawdowns and returns in real terms are particularly important for retirees - because the assets will be used to spend on goods (the cost of which is driven by inflation) and because unexpected down market returns in their portfolio are harder to recover from as someone gets to retirement age.
The chart below shows the cumulative real returns of an all stock portfolio - basically what Target Date Funds are providing to investors. Over the last 100 years there have been three big periods of drawdown amounting to 50 years of total experience! And those drawdowns have been very deep - a couple at 50% in real terms and after the depression 70% in real terms. Those are the types of outcomes that are ruinous for a retiree.
It doesn't have to be this way. Even simple steps to improve diversification could significantly improve the outcomes for most retirees without sacrificing longer-term returns. In contrast to a long only portfolio of stocks, consider a portfolio that has 50% of its risk allocated in stocks, 25% of the risk in bonds, and 25% in a diversified portfolio of commodities like gold, oil, copper, and wheat. On a long-term basis this portfolio returns on par with current Target Date Funds stocks for the long run portfolio.
But the outcomes in real terms are far less volatile than a stocks only portfolio. As you can see the portfolio delivers similar long term returns, but the drawdowns are less significant and much shorter than a typical target date fund portfolio (here as the 2065 mix).
Unlike many of these target date portfolios which are likely to have negative real returns drawdowns pretty frequently over a 10 year period, this simple 50/25/25 portfolio basically never sees a 10 year real return drawdown. It was only in a short period when Paul Volcker raised short-term real interest rates to their highest levels in history.
The current Target Date Fund approach is basically just a “stocks for the long run” bet. That creates a lot of risk that folks close to retirement will face a significant drawdown in their assets for a prolonged period of time. Even modest and simple adjustments to improve diversification would substantially reduce these risks without causing investors a projected loss of return. Let this be a challenge to providers to create funds that don't suck - it's a huge market and such a differentiated product could be wildly successful and beneficial to investors. And if it could be done in an ETF form to preserve tax efficiency so even taxable portfolios could benefit, all the better.