In part two I want to direct your attention to how target date funds are used in retirement. There are two different but interrelated goals for investments in retirement. First, provide a source of income, while second, maintaining (or building) wealth. On the one hand we want to create a consistent income stream for daily living. We want that income stream to be sustainable throughout our whole retirement (end of life). On the other hand we want to control the volatility of the account. Keep it steady. We don't want big ups and downs in the balance over time.
The problem is that while it may seem that the two goals are consistent, (steady income & steady balance), in fact pursuing both can be self defeating if you're relying on a target date fund. You see, most target date funds are concerned with just one aspect, controlling the volatility of the balance. It's not concerned with how to ensure there is a steady income stream over your lifetime.
Here's the important point. Creating a consistent income income stream and managing the account balance are two separate tasks. They are interrelated, and each needs to be managed properly to achieve success. The target date funds usually rely on bond funds to provide a steady (low volatility) account balance. As we learned in part one of this article, it does that without any consideration for the present state of the market. During retirement the target date funds simply assume that the bond funds will have low volatility and hence protect against major downturns in the market. In addition to that, they also fail to consider how the rate of return of the fund will support an income stream that most people want to be consistent over their entire lifespan.
In real life we need to manage and accept an appropriate level of volatility in our account balance in order to maximize the longevity of the income stream. Done properly, the account balance should be exposed to various investment options in order to capture returns in excess of bond funds for the very reason that bond funds may fail to provide the growth needed over your lifetime.
I'll end on this last note. Bond funds are often considered to be conservative (safe) investments with low downside risk. In fact, they can be subject to major and extended downturns. While individual bonds offer a degree of safety since they actually mature, target date funds are most commonly utilizing mutual funds with no termination date. If (when) bond yields rise in the future, the value of the bond fund shares will decline. This decline shows up in your account balance. We can only sustain consistent income withdrawals if our investment strategy achieves the level needed to extend our withdrawals to a reasonable life span.
It takes some thoughtful effort to understand how we are going to fund our retirement. It's worth the time and effort to understand this sooner than later.