I want to outline an unfortunate impediment to your financial success in future years. It has to do with the limited investment options provided by most work-based retirement plans—401(k), 403(b), etc.—and, more specifically, the inherent flaws embedded within the increasingly popular target date retirement funds. These limited options plus the current environment equals the 401(k) handcuff, and most people have no idea it even exists.
A very common list mutual fund offering within 401(k) retirement plans resembles something like this list below (which happens to be a real-life example):
1 Stable Value (Cash Alternative)
3 Bond Funds
1 Balanced (Stocks and Bonds)
8 Stock Funds
- 3 Large Cap
- 2 International
- 1 Mid Cap
- 1 Small Cap
- 1 Total Market (Large, Mid, and Small)
In reviewing these options, at first glance, average investors may conclude that the list is comprehensive. In addition, they might also assume that their employer performed a high level of due diligence and would only provide a plan that passed a rigorous examination.
On second thought, in light of our previous discussions, let’s examine these offerings more carefully:
The stable value fund offers little value, especially in this low-rate environment. The bond options are not appealing either if we are close to heading into a rising-rate environment. As we will analyze in the next chapter, there are some particular types of bonds that may be beneficial to hold, but these are very type specific and typically not represented in the limited options provided. The balanced fund is similar to the classic sixty‒forty portfolio that historically has suited many investors, but as this book outlines in great detail, it may not be as efficient moving forward.
The true deception is in the offering of the eight different stock funds. Most would conclude that this offers plenty of diversification. However, as we outlined with the correlation matrix, all those funds will move predominantly in unison together. Therefore, within stocks there will be no defensive mechanisms to protect the employee’s balance from the next major decline (as perceived diversification won’t). This leaves us with the most prominent types of offerings within the plan, which are the target date funds. Although they may appear to be tailored to your specific retirement goals, by listing your retirement date in the name of the strategy, I encourage you to reevaluate whether they are the best option for your savings.
Target Date Funds, Looking Under the Hood
Now that we have reviewed the potential dangers that a rising rate environment has on bonds, I can better explain my concern with target date retirement funds. The graph below is an example of how this company’s target date funds shift from stocks (equities) to bonds (short term and fixed income) over time. You will notice immediately that before and after “RET,” the retirement date, exposure levels to bonds increases.
My issues with this strategy:
Issue 1: As we outlined in chapter three, the entire portfolio manages risk based on time. No consideration is given to the individual investor’s unique personal risk tolerance.
Issue 2: Again, because it manages the asset allocation based only on time, this strategy does not factor in the current market environment. Knowing what you know now about rising rates and how they impact bond prices, this strategy warrants a rhetorical question. How would you feel if your target date fund began shifting more heavily into fixed income as rates began to rise?
Issue 3: The target date funds will invest in a broad array of bond funds. However, as noted in the next chapter, there is a definite pecking order regarding the best bonds to own in an environment of rising rates. Unfortunately, these funds will not handpick specific bond types. Instead, they will typically own a big broad basket and will increase this exposure as time elapses, perhaps even in the midst of rising rates. Again, these strategies give little consideration for the current environment (historically low interest rates), at a time when specific bond-type selection will matter most.
Sadly, these strategies are very prevalent within the work-based retirement plan, which is often the family’s largest investment account. The concept of target date retirement funds is excellent in theory. However, its lack of personalization and consideration for the current market environment is flawed and potentially risky for the unassuming investor.
What can you do to avoid the 401(k) handcuff?
Solution 1: Some employers are beginning to offer a do-it-yourself open architecture brokerage-linked option. This allows employees to manage their 401(k)s with a major brokerage house’s platform, which offers thousands of options. This is often better than the restricted options of their current plan provider.
Solution 2: Ask your HR department for the summary plan description of the work-based retirement plan. Many companies allow for in-service withdrawals. This allows current employees to roll over their current 401(k) balance to an IRA, even before separation from service, and where they can invest on their own with a major brokerage firm.
Both of these options are becoming more popular, and they both allow for a work-around from the 401(k) handcuff.
At this point you may be throwing up your hands in frustration assuming that there is no good place to invest. What the following chapters will introduce you to will require you to expand your investment horizons and step outside the box of conventional solutions. As a little taste of what is to come, and to provide a light at the end of this tunnel, five solutions are worth consideration:
1) Type-specific investments
2) Alternative asset classes beyond the traditional stocks, bonds, and cash
3) Tactical asset management, proactively adjusting allocation percentages to various asset classes factoring in the current market environment
4) Trend analysis
5) Self-directed investment accounts
To reiterate, you probably won’t find any of these options within your favorite savings accounts for retirement and college: 401(k)/403(b) retirement account and 529 college savings account!
The combination of interest rates near all-time lows and elevated stock valuations makes the investment environment for current retirees among the most challenging in history. Target date funds don’t solve the problem and may actually compound it by shifting to a higher percentage of bonds at a time when future returns from bond funds are likely to be significantly lower than in the past.
‒Ed Dempsey, CFP, CIO of Pension Partners