In late April and early May this year, many of the nation’s largest target-date retirement fund companies were patting themselves on the backs after their 2010 target-date funds “regained all the losses” they suffered from the 2008 crash. They wanted everyone to know that these investments turned out just fine despite the Great Recession and the 37% average loss that year for 2010 target-date funds. There was a big media push to get the word out to repair the fund companies’ images after many investors, on the verge of retirement, complained to Congress, the SEC, FINRA and the fund companies that their retirement savings had been mismanaged. Across the nation, lipstick headlines read “U.S. target-date funds recover ’08 losses”. But what they didn’t tell investors who were just two years from retirement was that the losses ran far deeper than a simple measurement of a mutual fund’s price. Let me explain.
For round numbers’ sake, let’s say your 2010 target-date fund hit an all-time high of $10 per share before the 2008 crash, and then it fell to $6.30 (-37%) at the bottom of the crater. Two years later, it reached $10 again. All is well, right? Unfortunately, no. All is not well. For starters, you lost three years’ (2008,’09 and ’10) worth of potential gains in your account that you were more than likely counting on. On the surface, that doesn’t sound like much, but when you are approaching retirement or already retired it’s significant. The reason is your time to earn money from working is either running out or already over. As such, taking a big loss near the end of your career or during retirement can cause damage well beyond the account’s current dollar value.
On the back of a cocktail napkin, let’s pretend you had $500,000 in a 2010 target-date fund before the crash and you were planning for an 8% average rate of return per year, which was a typical rate many plan participants were told was reasonable. When the market crashed, not only did your account drop to $315,000 (500K-37%), you also didn’t get the $129,856 during the 3-year recovery period that you might have been expecting ($500,000 + 8% + 8% + 8%). If you keep compounding the $129,856 for 10 years at 8%, without the 500K behind it, the amount is huge. It’s $280,344. That’s more than enough money to pay cash for the median priced home in the U.S. ($160,000) and put a fancy new car and Airstream camping trailer in the garage. Whether or not $280,344 is a realistic expectation is beside the point. It’s what you were planning for and nobody advised you otherwise. Advisors and fund companies simply didn’t do an adequate job managing your expectations or explaining the risks in more detail (keep reading).
Now, let’s talk about the after effects of the crash. In order to rescue our nation’s largest banks, the Federal Reserve injected stimulus in doses that dwarfed all previous interventions. I think it’s safe to say the stimulus efforts were the largest in the history of mankind. And like all stimulants, the Fed’s maneuvers had side effects. The Fed’s injections delivered staggering blows to our currency when it “printed” money and our government borrowed off the charts. As a result, the U.S. dollar is now worth less than it was at the top of the market in 2007, and it therefore purchases less (unless prices for goods and services have fallen an equal amount, which they haven’t, they’ve gone up). This means retirees need more money than they originally planned for to maintain lifestyles. It also betokens that despite the fact that your 2010 target-date fund hit $10 per share again in 2011, it’s not the same $10 it was at the top of the market in 2007. $10 in 2011 is more like $8.80 in 2007 terms, according to the roughly 12% drop in the Dollar Index.
Another factor you should be mindful of is that recoveries take longer when you are retired than when you are working, considering you are no longer making money and you are pulling money out of your account to pay living expenses. As such, getting back to $10 per share in the example above doesn’t make you whole again. You might need to get to $11 or more–maybe even $12 or more when you factor in the dollar’s reduced value.
Of course, mutual fund companies shouldn’t be held accountable for the dollar’s value, nor do fund companies imply that their investments will go up every year, but retirees need to understand all the risks and limitations associated with their investments. Moreover, you need to become more actively involved with your investments when they are being passively managed by your mutual fund company. It’s not their job to tell you to go to cash when going to cash isn’t isn’t an option in the strategy. You hired them to manage your money a very specific way, which didn’t include getting you out of dangerous markets. That’s a very serious limitation to be conscious of as you approach or enter retirement.
Conclusion
Even though the risks I outlined above are not being highlighted in the media, mutual fund companies are aware of them and retirees are now learning about them the hard way. And since many retirees’ savings are still far below what they will need to carry them through their golden years, they will have to increase investment risk, try to get a job in an awful job market, sell assets or all three. Mutual fund companies are playing catch-up, too. Some target-date funds are increasing risk to augment their average annual returns (read: Target-date retirement managers are taking too much risk for retirees in cyclical asset classes).
Despite the limitations and risks target-date funds pose to retirees, I want to point out that I think target-date funds are a big improvement over having plan participants choose from hundred or thousands of options. They are especially effective for younger investors who have plenty of time for recoveries after crashes. However, for investors who are close to retirement or already retired, traditional target-date funds have substantial risks the average investor doesn’t know about. As a result, the retiree needs to take control of that risk. Investors 55 years of age and up might consider a target-date retirement strategy that can go to cash in risky markets (read: Fusion Asset Management repackages its ETF strategies into revolutionary target-date retirement portfolios).
Next week I will post commentary about what some of the big target-date fund companies are planning to pitch to plan participants who retire and rollover their assets into IRAs. I’ll give you a hint. There could be a 6% to 8% commission off the top and 2% in fees every year thereafter. Subscribe to this blog and get the post automatically. The subscription link is at the top of the column on the right.
