When target-date funds are an ill fit for investors

An expert notes that many people aren’t the ‘typical investor’ that major brokerages expect

When target-date funds are an ill fit for investors

Target-date funds set up a globally diversified portfolio that’s deemed appropriate for investors at a certain age. But the problem, according to a finance researcher, is that many investors face circumstances that push them outside of what is considered “typical.”

“Based on research I have conducted, the typical investors (as the major brokerage companies define them) will obtain substantially all funds to finance their retirement needs from their financial portfolio and Social Security,” wrote William Reichenstein, Powers Professor at Baylor University, in the Wall Street Journal. “Second, all their financial resources are intended to meet their retirement needs.”

Reichenstein noted that typical investors have a portfolio of about 90% stocks until they reach their 40s; from there, the stock allocation typically decreases to 50%-55% until they retire at 65, after which it decreases further until it reaches 20% to 30%, years or even decades after retirement. At any point, 33% to 40% of the stock portion is typically placed in international stocks.

But he argued that nontypical investors — those who receive substantial funds from sources other than their financial portfolio and government-provided retirement income — should account for those other sources in their portfolio management.

A person who continues to work in their mid-60s, for example, could expect wage compensation that, similar to bonds, doesn’t vary with the stock market. That means a larger portion of their financial portfolio should go to stocks than a target-date fund would dictate for their retirement age. By the same reasoning, retirees who receive monthly defined-benefit payments or get annuity payments on top of their government pension should have a larger allocation to stocks.

Someone with an outstanding balance of US$75,000 on their mortgage should also make adjustments. “This mortgage essentially offsets US$75,000 of bonds held in a taxable account in his financial portfolio,” Reichenstein said. “Thus, he should maintain a lower stock allocation in his financial portfolio than the allocation recommended for a target-date fund for his retirement age.”

Finally, he argued, there should be a different approach for someone whose financial portfolio funds exceed the amount they need for retirement. Assuming the additional funds are meant as an inheritance for their children, Reichenstein argued, the excess amount should be invested in accordance with the longer investment horizon of the intended heirs.

“Thus, [the retiree’s] financial portfolio’s stock allocation should be larger than the allocation recommended in target-date funds for her retirement age,” he said.