In this week’s podcast the guys weigh in on whether or not target date funds are “good” investments for 401(k) investors.
They get into what target date funds get right, what they get wrong and why understanding a 401(k) plan’s default options are so important.
Is more education for investors really the answer? Tune in to find out.
This is a two part podcast as the discussion got in-depth and lengthy.
Be sure to check back next week for part two.
Check out our recent video to see if you are using target date funds correctly!
Are Target Date Funds Right For You? Part One – Full Transcript
**Click here for a full downloadable PDF version of this transcript!**
Casey Mullooly: Welcome back to the Mullooly Asset Podcast. This is your host, Casey Mullooly, and this is episode 377. In this week’s episode, Brendan, Tom, and I get into a pretty heated discussion about whether or not target-date funds are right for most investors. We get into, first off, what target-date funds are and why it’s so important for investors to understand what they’re defaulting into when they’re starting to put money into their 401(k) accounts.
Casey Mullooly: This is Part One of our discussion on target-date funds. We went pretty long and pretty in-depth, so we wanted to break it out into more digestible pieces for you, our listeners, so this is part one and part two will be next week. As always, we appreciate you tuning in and we’re just going to get right into it.
Casey Mullooly: All right, so we started talking about this because Tom Mullooly Mallouk, the CEO of Creative Planning, had a controversial tweet. He said how target-date funds are a terrible choice for most investors and that age-based portfolios shouldn’t be used for people investing in their 401(k) accounts.
Casey Mullooly: Target-date funds, for those who aren’t aware, are funds that are usually offered in 401(k) accounts, so everyday workers can contribute to them and they usually have a year attached to them. So, for example, a 2025 fund. A 2040 fund. A 2060 fund. The idea is that you pick the fund with the year that matches up with your anticipated retirement date or the year you turn 65.
Tom Mullooly: The idea behind that is that if you’re 30 years away from that date it’s going to be more aggressively invested, but as you get closer to the actual date of your retirement, the date of the fund, whatever, as you approach that date it gets less and less aggressive automatically. You don’t have to do anything. So, it will rebalance between conservative and aggressive investments as you move further towards that goal.
Casey Mullooly: Right, the target-date fund is a fund of funds so you’re, in most cases, owning a broadly diversified portfolio in one wrapper, so to speak. So, you don’t have to make any changes. You don’t have to rebalance the portfolio.
Brendan Mullooly: These are usually a default that you’re sent into as a new participant in a 401(k) plan to a target-date fund that matches up loosely, again, with your age and when somebody might expect somebody of that age to retire. So, sometimes it’s not even a choice. People are using these and they honestly don’t even know. They just know that they contribute to a 401(k) and that’s it.
Tom Mullooly: Prior to 2006 the default option in retirement plans, whether it was a 401(k) or something else, was cash. Was money market and so
Brendan Mullooly: That’s my that’s my biggest thing. They’re a terrible choice compared to what? Right? Because compared to cash I don’t think Tom Mullooly or anybody else would argue that investing in a target-date fund is a terrible choice if the alternative were that you were defaulted into cash paying zero. Or 1% if it’s a stable value fund or something of that nature. Come on.
Casey Mullooly: So what happened in 2006?
Tom Mullooly: They passed this retirement plan reform, “Hey, we can’t use cash as the default option in a 401(k).” And the money market option had just broken below 2%. And so it was like, hey, people could be in these retirement plans at work for 25, 30, 35 years earning nothing.
Brendan Mullooly: It’s the riskiest possible thing that somebody could accumulate their retirement savings in is cash. They have no growth, no opportunity stay ahead of inflation or grow the money at all. So, and obviously you can argue over any quarter calendar year period, whether it was riskier to be in a blended portfolio of stocks and bonds or not, but over a 30 year period or a 20 year period, I mean, cash is the worst choice that you could make.
Brendan Mullooly: So don’t default people into it because a lot of people are going to roll with the default because they don’t want to do anything above and beyond or where they just don’t feel comfortable in making that decision on their own and so they’re taking it as an implied endorsement which, again, I think you could debate whether that’s perfect or not, but to say that it’s a terrible choice I think is pushing it a little bit. I think it’s pretty good and pretty good beats some of the alternatives that we’ve seen for people trying to DIY or people who just defaulted into cash for decades on end.
Tom Mullooly: And I think that as 401(k)s became more and more popular in the eighties and then into the nineties even if your default option was cash which it was for 15 years or so through the eighties and into the nineties you were earning 4%, 5%. Not the worst thing in the world by just sitting in cash.
Brendan Mullooly: In real terms, though, you be earning nothing.
Tom Mullooly: Oh yeah, because inflation was eating away at that.
Brendan Mullooly: Interest rates were that because that’s where inflation. Loosely. I understand the Federal Reserve changes interest rates based on what’s going on in the economy and what they want to generate too.
Tom Mullooly: But there was some positive return in it just because rates were where they were. So by the time 2006 came around and they enacted this change into the target-date funds you had folks who were defaulted into the cash or money market option in their account and for 10 years had probably not made money because there was no nominal return on their money market fund and very likely because of inflation like you pointed out. They were falling behind.
Casey Mullooly: If I was a person who defaulted into cash or a money market fund in my 401(k) account and then didn’t know better, was just piling money into there.
Tom Mullooly: I’ve met a few of them.
Casey Mullooly: Then you lump sum back into now a target-date fund. Well, you could have been buying 8, 9, 10 years ago prices, but now you’re buying higher, most likely, so I’d be pretty ticked off if I were those people.
Brendan Mullooly: Even if you were diligent about it. Let’s say you didn’t change the default even though you could. If you default into cash and then you were paying attention and let’s say a few times a year you were going and so that means a few times you had to go in and make a market timing call and say whether it was a good time to put a lump sum of cash to work or not.
That seems like an unnecessary amount of thought that you’re then putting onto somebody who doesn’t do investing as a professional. Not that that would make their timing luck any better or worse, but there’s always something to worry about so if you’re relying on people to decide to take a lump sum of cash and invest it at any point in time whether they’re a professional investor or not you’re going to be able to come up with reasons why you shouldn’t do it.
Brendan Mullooly: So, yeah, the component of making it a default that’s being invested into something that has some level of risk exposure that may or may not be perfect depending on the person we’re talking about and that it’s happening every two weeks. That’s just a vast improvement and obviously different target-date funds build their portfolios differently and one of Peter’s points was, “Hey, we think you should take a risk-based approach as opposed to just assuming somebody’s age should dictate their investment mix.”
Brendan Mullooly: I agree with all that, but I also think that we’re most of the way there with target-dates as a default and I think they’re doing more good than harm.
Casey Mullooly: Agreed.
Tom Mullooly: That the target-dates are doing more good than harm.
Brendan Mullooly: Yeah, the target-date funds are doing more good than harm. Yeah, for sure.
Tom Mullooly: I think a lot of this is also making sure that participants in retirement plans at work are a little better educated in how this all works. I can tell you from experience some of these conversations that I had with folks 25, 30 years ago, late eighties into the nineties, we would talk about, “What about your 401(k) at work?”
Tom Mullooly: “Oh, that’s no good. It only pays 4%.”
Tom Mullooly: Or we’d talk about opening an IRA for someone and be like, “Well, what does that pay?”
Casey Mullooly: It depends.
Tom Mullooly: We’re going to invest it. We’re going to put the money to work in the market.
Tom Mullooly: “Oh, well, you know, my savings bank on the corner said that I can get five and a quarter percent. That seems like a good IRA to me.”
Tom Mullooly: So, a lot of this has been just education over the last 20, 25 years about what you can do. That you do have these options. I think for a lot of people in the mid two thousands when this change came about to start using target-date funds as the default option they were like, “What are you talking about? You can do this?”
Casey Mullooly: I think, “Yes.” But I also think it depends on… let’s just take someone starting a new job from scratch and they have a 401(k) plan and let’s say their company is matching. It depends on where the education is happening. So, if this person is starting a new job and wants to get the company match, then they’re just going to do it. I don’t know if they’re seeking out help at that point in time. I think one of Peter Mallouk’s points…again, he agreed that people need to be more educated on their choices and they need to make better decisions about it and not just default into whatever their 401(k)s default option is.
Brendan Mullooly: I just feel like the solution to tricky financial questions from people in our industry always just goes back to, “Oh, well, if we could just educate people better…” And that’s great and I agree it would be wonderful if everybody could be educated enough on how their 401(k) works to make a risk-based portfolio that uses the lowest cost funds that’s a fit for their situation and not an approximation based on their age or whatever.
I agree that ideally that is what you would want. However, we also need to be realistic about how people…financial advisors don’t work with everybody and lots of people have 401(k) plans that just don’t have the situation or the inclination to seek out help from a financial professional and so the idea that we’re just going to educate this problem away. I think it’s a pipe dream.
Brendan Mullooly: We need to meet people where they are and for most people this isn’t something that they even want education on. They just want to make sure they’re doing something reasonable and I think that’s what the target-date is fulfilling. It’s not the best possible solution, but who’s going to work with all these people and educate them. What kind of education are they getting? That there’s bad stuff out there too. So who’s going to make sure they don’t get that.
Tom Mullooly: I was just going to say there’s good education and bad education when it comes to returns.
Brendan Mullooly: There’s a market timing newsletter for the government TSP plan that you can sign up for. That’s not education, that’s education. That’s crap.
Casey Mullooly: Air quotes education.
Brendan Mullooly: Yeah, and that’s trash.
Tom Mullooly: That’s bad education. I also think part of, air quotes, bad education when it comes to retirement plans is a couple of lines that we hear all the time.
Tom Mullooly: “You should sign up for the retirement plan on the first day you start working.” I don’t necessarily agree that that’s good advice for every single person out there because there may be people who are just upside down on their balance sheet and they have just tons of debt and, you know what, they what they need to dig out of their hole first before they start worrying about an event that’s 65 years in a few, or…when they turn 65. 40 years from now.
Likewise, I think part of poor education is when people discover, “Oh, I want to buy this house and I’ve been socking money away into this retirement plan, and I just found out that I can tap into that money.” Like, holy crap, please don’t do that. That’s not what this is for, but people do it all the time.
Brendan Mullooly: Well, you know, I agree with that on one hand, but that’s also kind of the education solution because we’re…hypothetically, let’s say, we’re talking about somebody in that situation who just started a job. Who’s been defaulted into something like a target-date fund and defaulted in at, let’s say, 3% because the company will match to that and it’s free money if they want to get the 3% match from their company. So, they’ve been defaulted into a small contribution to get the match into a target-date fund.
Brendan Mullooly: What I’m saying is there are many worse things in the world than that and all of the things that we just talked about and what Tom Mullooly talks about. Getting a risk-based portfolio that addresses their specific situation and not just an approximation or, “Hey, should you be contributing at all? Let’s do some cashflow planning.” We’re talking about, then, a hypothetical person who’s working with a financial professional which is probably not happening.
Tom Mullooly: Right.
Brendan Mullooly: This is somebody fresh into the workforce. I’m just saying the odds of them getting good guidance from a financial professional at a cost that’s also a fit for their situation? Probably not happening.
Brendan Mullooly: So, absent that perfect world where they’re getting the guidance that considers all their needs and goals and things that they want, and building something that fits for it. I think the default settings are not so bad.
Tom Mullooly: I agree.
Brendan Mullooly: You’re in a target-date fund. It’s going to do something…one of the, I guess, criticisms was people are living longer. These target-date funds are getting more conservative sooner than they should be. Okay, that’s fine. If somebody is in an 80-20 mix when they’re 30 instead of being a hundred percent stocks because they don’t know any better and they’re just using a target-date fund what is the amount that they’re missing as a result of that and do we care? And what are the alternatives?
Tom Mullooly: Right.
Brendan Mullooly: It’s probably fine. It’s not going to be that much different if they’re 80-20, 60-40. First and foremost, let’s make sure they’re being invested into risk assets at all.
Casey Mullooly: They’re heading in the right direction.
Tom Mullooly: Yeah.
Brendan Mullooly: For sure. Obviously, part of our job is optimizing that stock-bond split. That contribution rate. All of those things, but we don’t work with everybody.
Casey Mullooly: Yeah.
Tom Mullooly: Yeah.
Casey Mullooly: We’re going to wrap up part one of our discussion on target-date funds here. Like I said in the beginning, we got pretty in-depth so wanted to break it out for you guys. Part two will be out next week for episode 378. As always, thanks for listening and we hope you got some good takeaways.
Speaker 4: Tom Mullooly is an investment advisor representative with Mullooly asset management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.