Last week I was meeting with a client, and we discovered a one million dollar mistake specifically related to Target-Date Funds in his 401(k). Are you making the same mistake? Let’s dig in and find out.
Currently, my client is investing $1,500.00 a month into his 401(k). That’s great, right? Well, when I looked at his allocation – where he’s putting the money – I noticed that he had all of his money flowing into a Target-Date Mutual Fund, or a Target-Date Fund.
What exactly is a Target-Date Fund? Well, you’ve probably seen one in your 401(k) if you have one. Typically, it’s the fund that has a date attached to it, like 2040 or 2050. The idea behind a Target-Date Fund is the fund company, XYZ Fund Company, grabs a group of their investments, a group of their mutual funds typically, and wraps them in a pretty wrapper. The fund company manages that set of investments for you, re-balancing them yearly, helping you “glide to” or “glide through” retirement with the return on investments you need. Yet, the closer you get to that target date of 2040 or 2050, the more conservative the Target-Date Fund becomes in nature.
Many people select these types of investments because they’re easy. The Fund Company picks stocks and bonds for you, manages the fund, and re-balances it yearly.
But in this client’s case, it was a one million dollar mistake.
So how did I come to that? The 10-year historical track record of this particular Target-Date Fund was 3.7 percent, and its beta – how volatile the fund is (does it bounce like a basketball?), was 0.87. A 1.0 beta mirrors the market, so this fund was less volatile than the market. However, it only returned over 3 percent.
After assessing my client’s risk tolerance, I built a custom investment portfolio for him using the available funds in his 401(k). Then, we compared it to the Target-Date Fund. The historical performance was a 7½ percent return from this custom-built portfolio, while the Target-Date Fund had done just over 3½ percent. Interestingly enough, the beta for the newly designed portfolio was 0.72, so it was less volatile – or less risky – than the Target-Date Fund, and it still earned more money!
Had my client left his money in the Target-Date Fund, he would have had roughly 1.1, 1.2 million dollars upon his retirement 20 years from now, assuming the Target Date Fund performed as it had in the past. By investing in a new portfolio of funds that had yielded approximately 3 percent greater returns on his investments, he’s now projected to have 2.1 million dollars in his portfolio upon retirement.***
3% matters! That’s potentially a full million dollars more, and all my client had to do was change investments within his 401(k). Obviously, his past performance is not indicative of his future results. Just because something did well over the last 10 years doesn’t mean it’s going to do well in the next 10-years.
Now might be the time to make sure you’re not making the same huge mistake my client was making. Go in and build an investment portfolio based on your own risk tolerance levels. And most of all, talk with your financial planner.
***I know that past performance is not indicative of future results and any assertion to the contrary is a federal offense. Furthermore, I am not saying that the funds will return the same going forward or that a change is always the right thing. All I am attempting to show is that ‘easy’, may not provide the results you desire. The allocation, risk, return, time frames, turnover rates, beta, alpha, R2, etc. were completely different in the two investment portfolios I compared. It was not a true Apples-to-Apple comparison. Please speak with your financial advisor about your specific situation or do your own due diligence.***