فصل 2 بخش 6

CHAPTER 2.6

MYTH 6: TARGET-DATE FUNDS: “JUST SET IT AND FORGET IT”

I am increasingly nervous about target-date funds with each passing day.

—JACK BOGLE, founder of investor-owned Vanguard

When you are looking at your 401(k) investment options, do you ever wonder just how they came up with that list? Or why your spouse or best friend who works across town has an entirely different menu of choices?

As the saying goes, always follow the money.

YOU GOTTA PAY TO PLAY

In the world of mutual funds, the common practice of sharing in revenues is known as pay-to-play fees. According to the Watson Towers worldwide consulting firm, approximately 90% of 401(k) plans require pay-to-play fees in exchange for placing a mutual fund as an available option on your plan’s menu. These pay-to-play fees virtually guarantee that the client (you and me) gets a limited selection and will end up owning a fund that proves profitable for the distributors (the broker, the firm, and the mutual fund company). Said another way, the “choices” you have in your 401(k) plan are carefully crafted and selected to maximize profits for the vendors, brokers, and managers. If one has to pay to play, they are going to want to maximize their profits to recoup their cost. And target-date funds, sometimes called lifecycle funds, may just be the most expensive and widely marketed creation to make their way into your plan’s investment options (with the exception being Vanguard’s ultra-low-cost versions).

DO TARGET-DATE FUNDS MISS THE MARK?

Despite being the fastest-growing segment of the mutual fund industry, target-date funds (TDFs) may completely miss the mark.

The pitch goes like this: “Just pick the date/year in which you will retire, and we will allocate your portfolio accordingly [the Golden Years 2035 fund, for example]. The closer you get to retirement, the more conservative the portfolio will become.” I am sure you have seen these options in your 401(k), and statistics would say that you are likely invested in one.

Here is a bit more about how they actually work.

The fund manager decides upon a “glide path,” which is the fancy way of describing its schedule for decreasing the stock holdings (more risky) and ramping up the bond holdings (traditionally less risky) in an attempt to be more conservative as your retirement nears. Never mind that each manager can pick his own “glide path,” and there is no uniform standard. Sounds more like a “slippery slope” to me. Then again, this is all built on two giant presuppositions: 1. Bonds are safe.

1. Bonds move in the opposite direction of stocks, so that if stocks fall, your bonds will be there to protect you.

As Warren Buffett says, “Bonds should come with a warning label.” And since bond prices fall when interest rates go up, we could see bond prices plummet (and bond mutual fund prices, too) if or when interest rates go up. In addition, numerous independent studies show how bonds have strong “correlation” in bad times. Translation: stocks and bonds don’t always move in opposite directions. Just look at 2008, when bonds and stocks both fell hard!

The marketing message for target-date funds is seductive. Pick the date, and you don’t have to look at it ever again. “Set it and forget it.” Just trust us! We’ve got you covered. But do they?

ONE GIGANTIC MISUNDERSTANDING

A survey conducted by Behavioral Research Associates for the investment consulting firm Envestnet found that employees who invested in TDFs had some jaw-dropping misconceptions: • 57% of those surveyed thought they wouldn’t lose money over a ten-year period. There are no facts to support that perception!

• 30% thought a TDF provided a guaranteed rate of return. TDFs do not give you any guarantee of anything, much less a rate of return!

• 62% thought they would be able to retire when the year, or “target date,” of the fund arrives. Unfortunately, this false perception is the cruelest of all. The date you set is your retirement year “goal.” TDFs are not a plan to get you to your goals, but rather just an asset allocation that should become less risky as you get closer to retirement.

Considering that there are trillions of dollars in TDFs, a huge percentage of Americans are in for a shocking surprise.

So what are you really buying with a TDF? You are simply buying into a fund that handles your asset allocation for you. It’s as simple as that. Instead of picking from the list of fund options, you buy one fund, and voilà! It’s “all handled for you.” SORRY, SHE NO LONGER WORKS HERE

After graduating college, David Babbel decided he wanted to work for the World Bank. It would no doubt be an interesting place to work, but for those fortunate enough to be employed there, they also pay no taxes! Smart man. When he applied they turned him away, saying he needed a postgraduate education in one of six categories to land a job. Not one to risk being denied a position, he decided to go get all six. He has a degree in economics, an MBA in international finance, a PhD in finance, a PhD minor in food and resource economics, a PhD certificate in tropical agriculture, and a PhD certificate in Latin American studies. When he returned with his fistful of diplomas, they told him they weren’t hiring Americans due to the recent reduction of financial support from Washington to the World Bank. It was a punch in the gut for him. Not knowing where to turn, he responded to a newspaper ad from UC Berkeley. After they hired him as a professor, he later found out that they ran the ad to comply with affirmative action, but had no intention of getting qualified candidates to respond.

Years later he moved on to Wharton to teach multiple subjects related to finance. But he isn’t just a bookworm. A paper he had written on how to reduce risk in bond portfolios caught the attention of Goldman Sachs. He took a leave of absence and spent seven years running the risk management and insurance division at Goldman Sachs (while still holding down a part-time professorship at Wharton). Later he finally had a chance to work at the World Bank. He has also consulted for both the United States Treasury and the Federal Reserve. But when the Department of Labor asked him to do a counterstudy on whether target-date funds were the best default retirement option, he had no idea the path that lay ahead. On the other side of the proverbial aisle was the Investment Company Institute (the lobbying arm for the mutual fund industry), which “had paid two million dollars for a study and got exactly what they wanted. A study that said [TDFs] are the best thing since sliced bread.” Keep in mind that at this point, TDFs were just a concept. A glimmer in the eye of the industry.

In his study for the Department of Labor, conducted with two other professors, one of whom was trained by two Nobel laureates, Babbel compared TDFs to stable value funds. Stable value funds are ultraconservative, “don’t have losses and historically have yields [returns] at two percent to three percent greater than money market funds.” According to Babbel, the industry-sponsored study, which painted TDFs in the best possible light, was riddled with flaws. To make TDFs look better than stable value funds, they pumped out more fiction than Walt Disney. For example, they made an assumption that stocks and bonds have no correlation. Wrong. Bonds and stocks do indeed move in step to a degree and they move even closer during tough times. (Bonds and stocks had 80% correlation in 2008.) Babbel and his team reviewed the study and picked it apart. They had mathematically dissected the report’s fictional findings and were prepared to show its ridiculous assumptions that made TDFs look so superior.

When he showed up on the day to present his conclusion, the economists behind the table, chosen by the Department of Labor to judge both studies, “thought he had some great points that needed further review.” But the secretary of labor “had already made her decision and then quit the next day. She didn’t even show up at the meeting she had scheduled with him.” Dr. Babbel heard that it was prewired. The industry has bought the seal of approval it needed to write its own “fat” check.

Fast-forward, and by the end of 2013, TDFs were used by 41% of 401(k) participants, to the tune of trillions! Not a bad return for the investment community for a $2 million investment in a study Dr. Babbel and his esteemed economist colleagues called “heavily flawed.” A 2006 federal law paved the way for target-date funds to become the “default” retirement option of choice. Employers can’t be held liable for sticking employee money in target-date funds. Today well over half of all employers “auto-enroll” their employees into their 401(k). According to research from Fidelity, over 96% of large employers use these target-date mutual funds as the default investment of choice.

YOU NEVER KNOW WHO’S SWIMMING NAKED UNTIL THE TIDE GOES OUT

Imagine that it is early 2008, and you are closing in on your retirement. You have worked the grind for over 40 years to provide for your family; you are looking forward to more time with the grandkids, more time traveling, and just . . . more time. By all accounts your 401(k) balance is looking healthy. Your “2010 target-date funds” are performing nicely, and you trust that since you are only two years away from retirement, your funds are invested very conservatively. Millions of Americans felt this way before 2008 wiped out their hopes for retirement, or at least the quality of retirement they had expected. The list on page 162 shows the top 20 target-date funds (by size) and their gut-wrenching 2008 performances. Remember that these are 2010 target-date funds, so retirement was now only two years away for their investors. Notice the high percentage that certain funds chose to put into stocks (more risky) even though they were supposed to be in the “final stretch” and thus most conservative. To be fair, even if you are retiring, you must have some exposure to stocks, but at the same time, this type of loss could have devastated or at least delayed your plans for retirement.

LESSER OF TWO EVILS

When I sat down to interview many of the top academic minds in the field of retirement research, I was surprised to learn that they were all in favor of target-date funds.

Wait a second. How could that be!?

I shared with each of them much of what you have just read, and while they didn’t disagree that there are issues with TDFs, they pointed to the time before TDFs existed, when people were given the choice to allocate as they wished. This arrangement led to more confusion and, quite frankly, really poor decision making. The data certainly supports their point.

In my interview with Dr. Jeffrey Brown, one of the smartest minds in the country, he explained, “If you go back prior to these things [TDFs], we had a lot of people who were investing in their own employer’s stock. Way overconcentrated in their own employer’s stock.” He reminded me of Enron, where many employees put 100% of their savings in Enron stock, and overnight that money was gone.

When people had 15 different mutual fund options from which to choose, they would divide the money up equally (1/15th in each one), which is not a good strategy. Or they would get nervous if the market dropped (or sell when the market was down) and sit entirely on cash for years on end. Cash isn’t always a bad position for a portion of your money, but within a 401(k), when you are paying fees for the plan itself, you are losing money to both fees and inflation when you hold on to cash. In short, I can see Dr. Brown’s point.

If the concept of a target-date fund is appealing, Dr. Brown recommends a low-cost target-date fund such as those offered by Vanguard. This could be a good approach for someone with minimal amounts to invest, a very simple situation, and the need for an advisor might be overkill. But if you don’t want to use a target-date fund and instead have access to a list of low-cost index funds from which to choose, you might implement one of the asset allocation models you will learn later in this book. Asset allocation, where to park your money and how to divide it up, is the single most important skill of a successful investor. And as we will learn from the masters, it’s not that complicated! Low-cost TDFs might be great for the average investor, but you are not average if you are reading this book!

If you want to take immediate action to minimize fees and have an advisor assist you in allocating your 401(k) fund choices, you can use the service at Stronghold (www.strongholdfinancial.com), which, with the click of a button will automatically “peer into” your 401(k) and provide a complimentary asset allocation.

In addition, many people think there aren’t many alternatives to TDFs, but in section 5, you’ll learn a specific asset allocation from hedge fund guru Ray Dalio that has produced extraordinary returns with minimal downside. When a team of analysts back-tested the portfolio, the worst loss was just 3.93% in the last 75 years. In contrast, according to MarketWatch, “the most conservative target-date retirement funds—those designed to produce income—fell on average 17% in 2008, and the riskiest target-date retirement funds—designed for those retiring in 2055—fell on average a whopping 39.8%, according to a recent report from Ibbotson Associates.” ANOTHER ONE BITES THE DUST

We have exposed and conquered yet another myth together. I hope by now you are seeing that ignorance is not bliss. Ignorance is pain and poverty in the financial world. The knowledge you have acquired in these first chapters will be the fuel you will need to say “Never again! Never again will I be taken advantage of.” Soon we will begin to explore the exciting opportunities, strategies, and vehicles for creating financial freedom, but first we have just a couple more myths to free you from.