Scott, what do you see as the the problem with target funds? Is it that they just hold too much in stocks?

I do see that AAATX, which is a 2010 target fund, does continue to hold about 50% in stocks. So they're putting someone who retired in 2010 and may be 65 or 70 years old into a 50% stocks portfolio. Indeed, that's a higher percentage than I would have expected. Is that the point that you're making, Scott? What do you think the percentages should be?

Scott Brooks writes: 

To Charles and anyone who wants to read this: Prepare for a long missive.

Target date funds have a multitude of problems…I'll hit on a few.

First, they give retirees a false sense of security. A sense that they're being taken care of by these big firms that "know what they're doing".

So you see retirees who have most of their retirement tied up in investments (as opposed to pensions) still living with an accumulation portfolio (i.e. still trying to get big returns) who think they can pull 5% - 10% per year off their portfolio because they've got a portion of their assets in a target fund.

Look at what happened to the target funds from 4Q07 - 1Q09. Most of their assets get hammered by 30% - 60%.

So you have a retiree who has spent the last 2 or 3 decades in an accumulation mode with an accumulation style portfolio and now they've got to make the shift to a distribution mentality and distribution portfolio…..and they don't want to do that…they think they can still keep investing like they always have in the past. They still want to see their portfolio grow like it did in the 90's or like it did from 1Q03 - 4Q07, or like it did from 1Q09 - present.

They forget the downturns as they become further and further removed from the downturns (00, 01, 02 are a distant and almost forgotten memory and 08 is almost forgotten as well).

But they "kinda know" that they should (maybe) get a bit more conservative, so they bite the bullet and put a chunk of their portfolio in a target date fund and leave the rest in their accumulation style portfolio.

Then when another downturn hits like 00, 01, 02 or 08, they'll see their portfolio meltdown 40%, 50% and in some cases more. They'll find that their target date fund (maybe) didn't lose as much, but it still went down 30% - 40% (maybe more).

Now what?

As much as a volatile market helped them in the accumulation phase of their lives (i.e. via dollar cost averaging), pulling money OUT of the portfolio to live on (kind of a reverse dollar cost averaging) hurts even more than DCA'ing helped them.

The drag/strain of a withdrawal stream on a portfolio is bad enough, but when we have downturns like we've experienced over the last 15 years, it can be devastating.

So basically, my first gripe is that Target Date funds give a false sense of security to retirees and pre-retiress (and believe me, I see it every single week) that they are not more conservative and the TDF portion of their portfolio is safe.

My other gripe is that Target Date funds have a problem with competition. When things are going well, (as they have for the last 6 years or so), people start to get antsy because of the lower returns of the Target Date funds. So eventually, after watching their friends get higher returns (sometimes substantially higher), people start to migrate out of the TDF's.

TDF's know this and they want to not only keep their current clients, but they want to attract new investors as well. So they have to "juice" the returns a bit by holding a bit more stock than they otherwise should. For example Charles made the comment about the 2010 TDF holding 50% stock and 50% bonds for clients that are ostensibly 65 - 70 years old.

Based upon "conventional wisdom" and "rules of thumb" (assuming you accept that claptrap), doesn't 50% stocks seem a bit high?

And if you're smart enough to see thru that line of BS (i.e. 100 - your age = % of stocks you should hold) you'll also notice that investing in bonds (especially right now) is not really a "risk decreasing move". Is anyone naive enough to think that interest rates are going to stay down forever? When they do start going up, we all know bonds probably aren't going to like that very much and I feel safe in summarizing that stocks won't like it either.

Yet people believe that 'ole line of horse manure sold to them by the "big mutual fund companies" that the TDF's are going to take care of them and that they've decreased the risk in their portfolio by making the switch to XYZ fund companies TDF group.

But what if interest rates never go up again? Are holding more and more bonds a safe way to go now? Well, the old phrase "you can't get there from here" comes to mind. By that I mean with interest rates so low, the bonds aren't yielding enough to make them worth the risk associated with the "butt kicking" that may some day come if interest rates go up.

But back to my earlier point about the TDF's having to "juice" their returns to help quell capital outflows while also attracting new money in. If interest rates stay low they've got to increase their stock holdings just to keep the peasants happy. So they decrease bond positions and increase stock position. So basically, even if interest rates stay low, the TDF managers just become part of the parade of people that are helping to build the next bubble (the next bubble being whatever the fund managers are investing in to get good returns that eventually will come crashing back to earth someday)

Look, I'm not telling anyone on this list anything they probably didn't know already. We all have a basic understanding of how markets and economies work.

But the average guy out there, Johnny and Sally Lunchbucket DOES NOT HAVE A CLUE!

They have little or no pension. They do have SS.

But what they've got is a nest egg in their 401k/403b/457/IRA/Roth/etc. And that nest is a LOT of money (at least to them).

Here's an example of what I see.

Couple aged 65 has:

$250,000 in an IRA

$100,000 in a TSA

$100,000 in an 401k

$150,000 in a brokerage account

$40,000 in the bank (I don't count bank "cash" money in my financial planning equations. This is "emergency fund" money that gives them "peace of mind" knowing they can get to it).

They've got $3,000/month of SS (between the two of them) coming in They've got $2,000/month of pension (between the two of them) coming in Therefore, they have a total of $5k/month coming in each month for them "to live".

When one of them dies (usually the husband in most cases), they are going to lose the lessor of the two SS and lose $500/month of pension income….but that's another problem to discuss on another day.

The problem they have is that (while both of them are alive) $5,000/month is not enough for them to enjoy the life they've worked 40 years for to have in retirement. They need an additional $1,000/month. So they need $6,000/month "to live"

They also want to have an additional $10,000/year "to have a life" (go on cruises and other trips, help the grandkids when needed, etc.).

So far, this seems pretty doable, right? Between the $1,000/month ($12,000/year) "to live", and the $10,000 they need "to have a life", they only need to "withdrawal/strain" their portfolio for $24,000/year (or 5.8%/year). They seem like they're in pretty good shape right?

Yeah, they're fine as long as 2008 doesn't come along again and knock their $500,000 nest egg down by 45% to $275,000 (Which is what will happen to them even if they own a TDF's). (And yes, I know their total nest egg is more $640,000, but bear with me for a moment and I'll account for the rest of the money in short order)

Now, when 2008 or 2000/2001/2002 happen again, they either have to drastically change their lifestyle or very much run the risk of running out of money. Maybe they just curtail their lifestyle for the 5+/- years that it takes for the market to recover. But at age, 65, how many "5 year curtailments of lifestyle do you want to take"? You don't have much time left and you certainly don't want to waste any time waiting for the money to come back.

So what SHOULD they have done?

Here's what I would do for them.

I'd take $240,000 and put it into a private pension annuity (yeah, I know we all hate annuities, but bear with me here). That is going generate for them a guaranteed monthly income of AT LEAST $1,000/month (keep in mind that is the guaranteed minimum….it could be higher). I would almost certainly use a fixed indexed annuity (don't fall for the variable annuity and it's "potentially" higher returns game here…remember, in retirement it ain't about the gain, it's about the losses).

I would then take $260,000 and put it into a mix of low and moderate risk private money managers who focus on risk management (i.e. decreasing beta by 50% - 80%) so that I can generate for them the $10k they need to "have a life".

Now, what have I done.

I've guaranteed that this couple is going NEVER run out of money because they have their pension, social security, and private pension annuity. So, at the very least, they have the peace of mind to know they'll, at least, be able "to live".

Since I'm using low/moderate risk money managers and properly allocating their investments over multiple asset classes, they have a very high probability that they'll continue to get their $10k/year of money "to have a life".

Also, if the private money managers only continue to perform at 80% of the level they have in the past, we'll also be able to offset the ravaging effect of inflation on their spending power over the ensuing years.

Now, if you've done your math, you've noticed that I still have $140k of money left over in their portfolio. What should I do with that.

Well, now we've got to take care of the other big problem that plagues seniors…..Long Term Care.

But who wants to pay for a LTC policy that could (and likely will) skyrocket in price over time.

So what I do is take $100k and I put it into a Life/LTC Combo policy that qualifies under IRC 7702 and 101c. This is a hybrid life insurance policy that allows you to use the death benefit for LTC (you can usually access up to 2% of the DB/month for to pay for LTC).

They both end up with a policy that has (give or take) approximately $250,000 of DB on each of them, that guarantees that the internal premiums can never go up (this is very important for LTC which is NOTORIOUS for massive premium increases), pays them a decent interest rate on their money in the plans (keep in mind that the interest they pay you is usually eaten up by the cost of the insurance but the benefit of this is that it allows you to pay for the premium with pre-tax dollars while still enjoying the benefits tax free), and the policies can be shared by each other (i.e. if the husband needs nursing care and uses up his entire $250,000, he can then dip into his wife's LTC plan and use up her $250,000).

I would then set them up with an attorney who would make sure that they have a good trust in place with proper POA's (health directive and POA for asset management) and also put together a Medicare Trust for them so that they only need to really worry about LTC for no more than 5 years after the trust is set up.

That leaves $40k of money that they have in the bank. That money stays right where it is. That's the amount of money THEY NEED to have the peace of mind that they've got an emergency fund handy that they can get to by driving down the street to their local bank. This is important the Lunchbuckets to have easy access to this emergency fund money…..JUST IN CASE.

Then, I would meet with the Lunchbuckets at least once per year (usually more like 2 - 4 times per year). My staff would call them at least monthly, they would get a monthly newsletter from me, and I would make sure that they attended at least 2 - 6 client events (dinners, client appreciation events, etc.) so that I CAN MANAGE THEIR EXPECTATIONS AND THEY CAN ALWAYS SEE THAT I AM PROACTIVELY DOING EXACTLY WHAT WE SAID WE WOULD DO AND THAT THEY ARE STILL ON COURSE TO ACHIEVE THEIR GOALS AND THAT THEY DON'T START TO GET ANTSY ABOUT WANTING HIGHER RETURNS OR GET TOO SCARED WHEN THE MARKET MOVES AGAINST US. I MAKE SURE THAT THEIR CLIENT BINDERS ARE UP TO DATE SO THEY CAN EASILY REFERENCE THEIR GOALS AND CLEARLY SEE THE PROGRESS WE ARE MAKING TOWARDS THEIR GOALS.

At this point, it's all about managing expectation and being there for them when they need me.

Now, after all this, let me remind you that we're not talking about sophisticated people here. We're still talking about Johnny and Sally Lunchbucket. But everything that I've laid out above (may) seem(s) like sophisticated planning…..AND IT IS….to the Lunchbuckets.

But the Lunchbuckets don't know about this stuff. All they know is what their Edward Jones broker (who has them in the same things he did when they were in the accumulation phase of their lives….and, quite honestly, sells the same crap to all his clients because he makes a higher commission by selling "certain" products) or their UBS broker, or their Wells Fargo broker or their "regional brokerage firm" broker, or their cousin who sells insurance and mutual funds (all of whom have the same conflict of interest issues that the Edward Jones broker has) has told them. And what they've been told by these "professionals who were smart enough to pass a series 7 exam" (which you don't have to be very smart to pass) is the is the same failed BS claptrap that they've been told for years….except it's been repackaged to fit the times…..i.e. repackaged as Target Date Funds (or some other equally slimy crap).

And the next time the market corrects, the Lunchbuckets are going to get HAMMERED…..and they're going to be told by their broker to "stay the course", "hold on, it will come back", "we gotta take the lows and the highs".

But the Lunchbuckets won't like that. They'll feel a gnawing sense of anger and an increasing pit in their stomach as they watch their portofolio melt down further and further and further. And they'll get angrier and more desperate as the market starts to recover and their portfolio doesn't recover as quickly because:

1. They sold stuff near the bottom in a panic or

2. Their broker got scared and put them in more conservative investments (you, now high sell low) or

3. Or they kept making withdrawals on the way down and had to sell more and more shares just to get the same amount of money and now they don't have enough shares to facilitate continued withdrawals and allow the portfolio to recover, or

4. Maybe they believed the Vanguard BS or their broker was lazy and they ended up with TDF's. TDF managers that are now in a panic because they didn't protect their investors at all and so now they all of a sudden want to get more conservative to show that they're at least doing something, even though it's "too little, too late" and they end up buying high and selling low.

I've been typing for some time now and I think I've gotten off on more than a few tangents and strayed from the original question about why I have a problem with TDF's.

What it comes down to for me, in a nutshell, is that TDF's are just a gimmick put forth the financial services industry to gather assets by telling investors a new twist on the same old line of BS that the financial services industry has been spewing from their lying mouths for years.

The Lunchbuckets used to get pensions managed by professional and prudent companies (usually insurance companies were the best at this) and they knew that between their pensions and SS, they were going to be able "to live' in retirement.

Now, the Lunchbuckets don't get enough (or any) pension and they have to figure out how to take care of themselves. Their pension has been replaced by a large barrel of cash in the form of 401k's/IRA's/403b's/457's etc. that the Lunchbuckets are woefully unable to handle themselves…..so they get preyed upon by the predators and scavengers who infect the financial services industry.

Now, some of these scavengers and predators are naive' and ignorant about the havoc they are reeking upon the lives of those that they call clients. They are just following the company line and doing what they are told by their "superiors and bettors that are higher up the food chain". Some of the scavengers and predators figure out the harm they are doing (or they are willfully ignorant), but are so addicted to the lifestyle and the money (where else can a schmo go and make ball player money?) that they rationalize what they are doing so they can stand to look themselves in the mirror or face their wives and children.

That is, in part, the problems I have with Target Date Funds…..target date funds are just a symptom of the many problems that plague the financial services industry.

anonymous writes: 

Nice work, Scott. Your clients should be grateful that you're doing this kind of thinking for them.

I guess I'd say there's nothing intrinsically wrong with the idea of "target date" funds, but Scott's saying that 1) these funds remain too heavily weighted in equities as the target date approaches and passes and 2) they often allocate reactively in a "CYA" kind of way.

I agree that annuities should play a role in most people's retirement finances, but I would need a pro like Scott to wade through the annuity world–they're complicated. I also came to the same conclusion as Scott regarding long term care insurance, which seems like a "heads we win / tails you lose" kind of deal for the insurers. Packing it into life insurance seems promising, though again, I'd want someone like Scott who is honest and immerses himself in this stuff to help me figure it out. 


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