3 Things to Consider When Using Target-Date Strategies

Investing
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By Jeff Foster, CFP®

Learn more about Jeff on NerdWallet’s Ask an Advisor

We’ve all seen them in our 401(k) accounts, and most of us have used them. The Target Date Retirement Strategy has long been the default investment selection among employer-sponsored retirement plans. These strategies are based on a single piece of information about investors: their age – and thus their expected retirement year. But what are these strategies really doing? How are they investing? Does one size really fit all? First, we need to take a look at how the majority of these strategies work.

General investing principles state that as you approach retirement, your investment allocations should become more heavily weighted in fixed-income securities (bonds) and your holdings in equities (stock) should be reduced. The thought process behind this is tied to the perceived riskiness of these two basic asset classes. As you approach retirement, you want to protect the nest egg you have built, so you take risk off the table by moving out of equities and into bonds. The basic concept isn’t inherently bad. In fact, it can work very well for some people. However, is a one-size fits all strategy right for you? Here are three things to consider before using these strategies:

1. What else do you have?

For some people, the assets in their 401(k) plan are the only assets they have to put toward retirement. However, many people will have multiple sources of retirement income; pensions, inheritances, real estate, life insurance cash balances, stocks and bonds, and other forms of assets will contribute to providing income in retirement. If these strategies don’t take into account the other assets available to an investor, they could very well be leading to unnecessary risk, or lack of true diversification amongst assets.

2. Are you ahead of schedule or trailing behind?

Let’s say, for instance, that you have determined you need $1 million at retirement to provide the lifestyle you desire after you finish working. Perhaps you have been a disciplined saver and have accumulated 80% of this target in your 401(k) with 15 years until retirement; you may be way ahead of schedule! By still sitting in a retirement target-date strategy, you may remain heavily weighted in risky assets. Do you really need to take this extra risk? The answer is “no.” The same can be said for those who may have been late in starting their retirement savings. Perhaps extra risk should be considered in an attempt to catch up!

3. Do you know where bond prices are going?

Most of the retirement target-date strategies balance risk and return using bonds. In a rising interest rate environment, investors should consider the risk of falling bond prices and the result it could have on returns. An approximate measure of the interest rate risk that a bond, or portfolio of bonds, carries is duration. Duration is defined as the approximate percentage price change in bonds, given a one percent change in interest rates.1 Hypothetically speaking, a bond with duration of 7 would fall approximately 14% given a 2% increase in interest rates.2 You can see why a strategy heavily weighted in bonds, during an environment of rising interest rates, could have devastating effects on a portfolio.  There are other types of investments that can work to reduce the overall risk of the equities (stocks) in a strategy, which should be considered in these market environments.

 

1. Market value of the bond can fluctuate and, if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.

2. This is a hypothetical example and is not representative of any specific security. Actual results will vary.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. No strategy assures success or protects against loss.