Traveling on the interstate can seem never-ending when headed to a faraway destination. What better way to take it easy than turning on the cruise control until you arrive? While that sounds like an ideal plan of action, the truth is cruising along at the same speed the whole time may not always be the best option—on the trip and in financial planning.
Retirement is also like a road trip and target-date mutual funds are the cruise control. The problem with cruise control and target-date mutual funds—timing is everything. You may hit the occasional snag and need to slow down. Or perhaps you get a late start and need to accelerate to reach your destination. Whichever is required, it is a good possibility that a target-date mutual fund cannot give you exactly what you need, when you need it.
Just this last week I met with a client and together we began a review of his portfolio. We had already identified his goals and generated a written financial plan in previous meetings. I was digging into the investments within his portfolio to gauge where he stood versus where he should be to meet his goals. Whenever I jumped into his current 401k, I noticed he had selected a target-date mutual fund—like many people do.
Here’s the skinny on what target-date mutual funds are. Basically, you are 35 years old today and plan to retire at 65. That would mean you will retire in 2047. Since you know that, you choose this vehicle that is going allocate your investments for you based on your target retirement date of 2047 (actually it will be either 2045 or 2050 because most target-dates are designed on 5-year increments). It is simple—cruise control. You don’t even have to make any other decisions. The mutual fund company usually picks about 10 – 20 mutual funds within their company’s array of investments to invest your funds for you. They build you a portfolio “diversifying” your shares within their company.
While you are younger, it will likely start out more aggressively and as you near your target-date of 2047, your portfolio automatically shifts to a more conservative mix. And what I mean by more conservative is the mutual fund company shifts from the aggressive stocks into the conservative bonds.
Now, I personally do not like target-date mutual funds. Actually, I HATE THEM! First of all, I don’t like them because most people don’t even know what their investments are in their target-date fund. Secondly, the results from using target-date funds are typically not very good; or, in my experience, not as good as you may be able to achieve by designing your own portfolio. Honestly, they are horrible. There just is not a one size fits all for investing, which is what these investments assume.
Let me break that down mathematically for you. For that particular client, when I ran the numbers for their target-date fund over the last 10 years their return was 3.77%. When you add 3.4% back into the equation for inflation (a historical value) you then get an actual return of 0.3%. That’s not really a very good return for 10 years of investing.
How about the beta or the volatility measurement? When we look at that 10-years, it’s 0.89% (less than 1% are less volatile than their benchmark, whereas those over 1% are more volatile). So you can see it was a pretty steady investment, with a fairly low beta, relatively speaking.
Knowing all of that, I took the funds available within this plan and designed a portfolio based on their risk tolerance. Keep in mind that a target-date fund and a custom portfolio are not an apples-to-apples comparison. We were still able to build a comparable portfolio for the same 10 years in this hypothetical example. This time the return of the portfolio was 7.6% over the same 10-year time frame. When you factor in the same 3.4% for inflation, the ROI is now significantly more—4.2% to be exact. I was also able to shift the beta from 0.89% to 0.72%. So overall, we are dealing with about a 3% greater return in those 10 years, with less volatility. Keep in mind that past performance is not indicative of future results.
Obviously, I know there are some people who want to focus on the standard deviation and the Alpha. For those who do, this target-date fund had a standard deviation of about 15.3%. The Alpha for those 10 years was 1.6%. Now when I compared those numbers to the new portfolio that I built, we still see a significant difference. The new portfolio boasted a standard deviation of 11.63%, while the Alpha for the same 10 years was now 5.2%. Again these are significantly different numbers equaling more reward with less risk.
Maybe you are thinking “big deal, it’s just 4.2%”. However, if you take a $50,000 portfolio over this 10-years and plug in the numbers above, that’s a $34,312.00 difference. THAT IS A TON OF MONEY!!
The bottom line is this. When you look at the way the portfolio works with the target-date, you could be dealing with hundreds of thousands of dollars difference over a 30 – 40 year accumulation period as you prepare for retirement.
The above example is not uncommon. I see math similar to this all the time. People take a job, sign up for the company’s 401k. They have no idea what to do when it comes to choosing the investments inside of it.
Additionally, they think they cannot afford to hire a financial planner to help them, so they go in and pick what sounds like a great idea, setting their retirement on cruise control—just driving itself.
Building a custom portfolio specifically tailored to your risk profile could make all the difference when it comes to hitting your retirement goals. Sure it may cost you anywhere from $500 to $2000 a year, but the truth is a CERTIFIED FINANCIAL PLANNER™ may help you get exactly where you are going. Don’t just use cruise control. Talk to your financial planner today and see what investments in your 401k best match your goals.