The average person saving for his or her retirement fund is often buffeted by a kaleidoscope of opinions and commentary on how they should go about doing so. Some of this advice is plainly self-interested, more designed to line the pockets of those giving the counsel than helping those at the receiving end. Other advice fundamentally misunderstands the purpose and objectives of retirement savings, whether in the form of a 401(k) or an Individual Retirement Account.
Unfortunately, Rob Arnott and Lillian Wu of Research Affiliates commits the latter error in their latest post on "What Are We Doing to Our Young Investors?" Arnott and Wu make the contrarian argument that, despite thier growing popularity, so called "target funds" are a potential disaster in the making, especially for millenial investors in their 20s and 30s. Target funds incorporate a pre-set allocation of funds among different investment classes to ensure that younger investors take more risk -- and hence increase their odds of greater growth -- while older investors carry a more conservative mix to better guarantee preservation of existing savings. Many target funds actually are nothing more than an agglomeration of existing funds -- a target fund for a 35 year old may incorporate a variety of stock funds and a mix of bond funds, but allocate the overwhelming majority of the money invested here into the stock funds. In other cases, a target fund is specifically created and managed as a stand alone entity.
Let's be clear -- target funds are not perfect. First, there is no clear uniformity or consistency in target funds across the industry. What Firm A may think is an appropriate level of stock exposure for a 50 year old may be quite different from how Firm B sees it. Accordingly, unless you read the fine print, you may find yourself in a target fund that has a very different conception of risk and reward from how you see things. Second, target funds often offer investment firms an excuse to tack on more fees. Even if it is a fund of fund approach, where firms are simply aggregating existing funds together, this offers an opportunity or excuse to layer on another ten or twenty basis points of expenses. An informed investor willing to dedicate a modest amount of time can easily replicate a target fund approach for his or her portfolio and bypass the added costs while ensuring an appropriately tailored risk level.
But Arnott and Wu are not criticizing target funds primarily because of inconsistent risk levels or added costs. Instead, they contend that because young investors who choose target funds are so heavily invested in equities, they will suffer disproportionately from any market downturn, which may in turn cast a permanent cloud over their investing appetites. Moreover, because so many young employees use their 401(ks) as a rainy day fund, they are most likely to raid these funds in the middle of an economic downturn, after they have lost their jobs and the market is in a prolonged funk. The bottom line: they not only sell their stocks after a significant loss -- the worst possible time to sell -- but also get hit with early withdrawal penalties and associated tax liabilities.
The authors are correct that many young employees behave in this fashion, owing largely to economic necessity: if you have lost your job, your immediate priority is to pay your bills so that you can remain in your apartment or house and put yourself in the best position to find another job. What may be prudent for a retirement that is decades away largely takes a back seat. Yet the problem diagnosed here is not with target fund investing, which is simply one way to save for retirement. It is rather a manifestation of a deeper set of flaws with our retirement savings approach and the 401(k) vehicle in particular.
Yes, too many employees use their 401(k) accounts as rainy day funds, defeating their entire purpose as retirement savings vehicles and incurring unnecessary costs when withdrawing these funds. Arnott and Wu declare that, given this reality, younger investors should take a more conservative approach to their retirement savings, and initially invest in bonds and other conservative investments to accumulate sufficient savings for a rainy day fund. But they fail to consider or explain why withdrawing funds from a more conservative mix of investments in your 401(k) is any smarter than withdrawing funds from an aggressive investment mix. You still incur a 10% early withdrawal penalty and you still forego the tax
Jofi Joseph is navigating a mid career transition into the accounting profession and earning his Masters of Accountancy at George Washington University. After securing his CPA, he intends to specialize in tax planning and compliance. In the meanwhile, he enjoys contributing to the debate over how Americans can more effectively save for their golden years.
Unfortunately, Rob Arnott and Lillian Wu of Research Affiliates commits the latter error in their latest post on "What Are We Doing to Our Young Investors?" Arnott and Wu make the contrarian argument that, despite thier growing popularity, so called "target funds" are a potential disaster in the making, especially for millenial investors in their 20s and 30s. Target funds incorporate a pre-set allocation of funds among different investment classes to ensure that younger investors take more risk -- and hence increase their odds of greater growth -- while older investors carry a more conservative mix to better guarantee preservation of existing savings. Many target funds actually are nothing more than an agglomeration of existing funds -- a target fund for a 35 year old may incorporate a variety of stock funds and a mix of bond funds, but allocate the overwhelming majority of the money invested here into the stock funds. In other cases, a target fund is specifically created and managed as a stand alone entity.
Let's be clear -- target funds are not perfect. First, there is no clear uniformity or consistency in target funds across the industry. What Firm A may think is an appropriate level of stock exposure for a 50 year old may be quite different from how Firm B sees it. Accordingly, unless you read the fine print, you may find yourself in a target fund that has a very different conception of risk and reward from how you see things. Second, target funds often offer investment firms an excuse to tack on more fees. Even if it is a fund of fund approach, where firms are simply aggregating existing funds together, this offers an opportunity or excuse to layer on another ten or twenty basis points of expenses. An informed investor willing to dedicate a modest amount of time can easily replicate a target fund approach for his or her portfolio and bypass the added costs while ensuring an appropriately tailored risk level.
But Arnott and Wu are not criticizing target funds primarily because of inconsistent risk levels or added costs. Instead, they contend that because young investors who choose target funds are so heavily invested in equities, they will suffer disproportionately from any market downturn, which may in turn cast a permanent cloud over their investing appetites. Moreover, because so many young employees use their 401(ks) as a rainy day fund, they are most likely to raid these funds in the middle of an economic downturn, after they have lost their jobs and the market is in a prolonged funk. The bottom line: they not only sell their stocks after a significant loss -- the worst possible time to sell -- but also get hit with early withdrawal penalties and associated tax liabilities.
The authors are correct that many young employees behave in this fashion, owing largely to economic necessity: if you have lost your job, your immediate priority is to pay your bills so that you can remain in your apartment or house and put yourself in the best position to find another job. What may be prudent for a retirement that is decades away largely takes a back seat. Yet the problem diagnosed here is not with target fund investing, which is simply one way to save for retirement. It is rather a manifestation of a deeper set of flaws with our retirement savings approach and the 401(k) vehicle in particular.
Yes, too many employees use their 401(k) accounts as rainy day funds, defeating their entire purpose as retirement savings vehicles and incurring unnecessary costs when withdrawing these funds. Arnott and Wu declare that, given this reality, younger investors should take a more conservative approach to their retirement savings, and initially invest in bonds and other conservative investments to accumulate sufficient savings for a rainy day fund. But they fail to consider or explain why withdrawing funds from a more conservative mix of investments in your 401(k) is any smarter than withdrawing funds from an aggressive investment mix. You still incur a 10% early withdrawal penalty and you still forego the tax
Jofi Joseph is navigating a mid career transition into the accounting profession and earning his Masters of Accountancy at George Washington University. After securing his CPA, he intends to specialize in tax planning and compliance. In the meanwhile, he enjoys contributing to the debate over how Americans can more effectively save for their golden years.