The Hidden Risk in Target Date Funds
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Choosing the appropriate target date fund (TDF) for an investor is not easy, given the large number of products in the marketplace and the lack of tools to easily compare those offerings. That choice, however, is made a lot easier if one focuses on the component of TDFs where investors are exposed to the greatest risk – what I call the “risk zone.”
The risk zone is the five to ten years before and after retirement. During this period, investors are least able to tolerate adverse market conditions, when significant dollar losses in their portfolio can be compensated for only by reducing their standard of living.
The risk zone is also critical from the plan sponsor’s perspective. Older, more senior, employees are more likely to sue, or at least make their voices heard, than are younger employees with smaller account balances. Employers should fear the risk zone for both its litigation threat and its importance to employee morale. Fiduciaries need to set objectives for the risk zone, and safety first should be the order of the day.
Glide paths of TDFs differ markedly as they approach and enter the risk zone, and this divergence creates a hidden risk for investors. Without understanding the implications of an excessively risky glide path in the risk zone, investors may face painful choices in their retirement. I have created a simple metric, which I explain below, that can help advisors and investors choose the right TDF.