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Your Target-Date Fund May Not Be Prepared For a Down Market

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After around a decade of near constant growth, the stock market has been falling in recent months and we are officially in a bear market for the first time in quite a while. For younger people this is scary, but they can take comfort in the fact that the bear market is not going to last forever and they have plenty of time to see their retirement investments rebound before they are actually ready to start taking money out. For those looking to retire right now, though, there are some serious risks. What’s more, target-date funds, the set-it-and-forget-it retirement option many savers have put their faith in, may have not sufficiently prepared for one of the biggest potential downfalls currently facing retirees: sequence of return risk.

For help managing your own retirement, including advice on preparing for sequence of return risk, consider working with a financial advisor.

Sequence of Return Risk Definition

You may not have heard of sequence of return risk, but it’s a serious issue to consider when planning for your retirement. Essentially, it refers to the idea that when a dip or spike in stock prices comes in relation to your retirement can mean the difference between a fully-funded and comfortable retirement and running out of money far too quickly.

Remember, your retirement savings are likely not held in cash, but in investments. When you start withdrawing money from your account in retirement, you sell off these investments for cash. Most people take a set amount of cash from their fund each year — the recommendation is 4% of your total amount.

The problem is that if you make your withdrawals during a downturn, you have to sell more assets in order to reach your withdrawal. This means that even if the market is destined to go up eventually, you’ll have fewer assets to gain value, costing you money in the long run. A study by Charles Schwab found that a retiree experiencing a 15% drop in portfolio value in year one of retirement will run out of money significantly earlier than someone experiencing the same 15% drop in year 10.

The Issue With TDFs and Sequence of Return Risk

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Target-date funds are financial instruments specifically designed with retirement savers in mind. They have a rough retirement date assigned to them, and investors pick the year that is close to when they are planning on retiring. The TDF will adjust the asset mix as a person moves towards retirement, focusing on high-growth assets like stocks when a person is younger and moving to more conservative picks like bonds and cash as retirement approaches.

One issue with many TDFs, though, is that they fail to account for sequence of return risk. Essentially, they don’t have enough money in safe investments at retirement. According to reporting from 401kSpecialist Magazine, most TDFs are still about 85% in risky investments at the target date. If you invest on one of these funds and reach your target-date during a down market — such as the one happening right now — you’d have issues.

The key to navigating sequence of return risk, whether for TDF managers or for individual investors, is to keep a reserve of money in either cash or easily liquified short-term bonds.

The Bottom Line

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Target-date funds are instruments designed for retirement savers, allowing them to invest on a glide path toward retirement without having to shift their investments themselves. One problem, though, is that some TDFs don’t account for sequence of return risk, which could leave retirees at a huge disadvantage if they retire during a down market.

Retirement Planning Tips

  • A financial advisor can help you come up with a plan to avoid retirement pitfalls. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Whether you use a TDF or not, make sure you contribute to your 401(k) if you have access to one — and take advantage of any employer match that is available.

Photo credit: ©iStock.com/Zephyr18, ©iStock.com/Delmaine Donson, ©iStock.com/ljubaphoto

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