Retirement
◄ back to all posts

Is Your Target-Date Fund Too Risky?

Written by John Coumarianos | Jun, 22, 2018

If you’re planning to retire in or around 2020, and you have most or all of your assets in a target date fund, is that fund too risky? It might be given current stock market valuations.

I recently published an article on how various allocations served a hypothetical investor retiring in 2000. Any backtest begun that year would admittedly be unflattering to stock exposure, but retirees must think in worst-case scenarios because they are at risk of running out of money. And stocks may not be much cheaper now than they were in 2000.

In that article, I used the following chart to show how each hypothetical portfolio performed using the so-called 4% retirement rule, whereby the retiree withdraws 4% from his account in the first year of retirement, and boosts whatever the dollar value of that initial withdrawal by 4% each year thereafter.

It turned out that a pure stock portfolio couldn’t withstand the 4% rule given the amount of declines in two bear markets – from 2000 through 2002 and in the 2008-early 2009 period. The original $500,000 would have declined to a little more than $100,000 in the 18 year period. A balanced portfolio did much better; it would be down to a little more than $400,000. A still more conservative portfolio – 30% stocks and 70% bonds – would have remained intact. In other words, the more bonds a portfolio had, the better it held up despite the fact that stocks outperformed bonds on a compounded annualized basis – 5.4% for stocks  versus 5.1% for bonds.

And now most 2020 retirement funds have more than 50% stock exposure, potentially setting up their investors for a bumpy ride and loss of capital. On our list of some of the largest funds with 2020 dates, only the American Funds offering and the JP Morgan entry have less than 50% stock exposure.

Stocks reached a Shiller PE (price relative to the past decade’s average real earnings) of 44 in 1999, and they are at 32 now. The 44 reading seems far away, but, besides that extravagant reading during the technology bubble, the metric has been over 30 only one other time – in 1929.

Moreover, the median stock, on a variety of valuation metrics, is more expensive now than it was in 2000. For example, GMO’s James Montier recently showed that the median price/sales ratio is higher now than it has been in any other time in history. During the technology craze, small cap value stocks and REITs, for example, were left for dead, and investors prowling for cheap stocks could buy them, and wait. They wound up delivering boffo returns for the next decade. From 2000 through 2009, when the S&P 500 Index delivered no return, the Russell 2000 Value Index delivered an 8.3% annualized return to investors. But now there are arguably no cheap parts of the market.

Valuation metrics aren’t crash predictors; they don’t tell you a crash will occur next week, next month, or next year. But it’s reasonable to anticipate that the higher valuation metrics go, the more likely a significant decline or significant volatility become. And big declines hurt retires withdrawing from their accounts dramatically.

It’s also true that foreign stocks are cheaper, but they’re not that cheap. GMO’s most recent asset class return forecast shows no region of the world is poised to deliver inflation-beating returns. That means target date funds may be putting their client assets unnecessarily at risk. In 2013, Jack Bogle argued that target date funds were too heavily weighted in bonds, potentially crimping investor returns. With a Shiller PE above thirty and bond yields creeping up, the opposite might be the case now.

Financial planner and author Michael Kitces has shown that the Shiller PE works well as a financial planning tool, indicating what future returns stocks might deliver over intermediate time frames — around 8-18 years. Though a bit short on details, Kitces argues that the metric can help retirees facing sequence of return risk by encouraging them to adjust their spending. But it’s unclear why the metric can’t influence gentle portfolio modifications as well. When the Shiller PE is over 30, the likelihood of robust returns — or even returns that can beat bonds, despite low yields — is diminished after all. Nobody should ditch all their stock exposure; markets can always surprise investors. But retirees face such a harsh outcome if their portfolios suffer big declines during the first decade of retirement that modest stock exposure — even less than 50% stock exposure — appears the most prudent course. Unfortunately, judging from their allocations, target date funds may not be aware of the risk they’re imposing on their shareholders.

Target date funds are allocated based on investors’ distance from their spending goals. Even setting aside the difficulty of the retirement spending goal, which run over years and decades, distance from goal shouldn’t be the only consideration in answering the allocation question. Target date funds should also consider valuation and sensitivity to volatility.


Talk with an Advisor & Planner Today!

John Cumarianos Signature

John Coumarianos is an Analyst for Clarity Financial, LLC, and is a contributing editor to the Real Investment Advice Website. He has been an analyst at Morningstar and a writer for MarketWatch and the Wall Street Journal. Follow John on Twitter.

2018/06/22
◄ back to all posts