Target date funds: Warnings for near-retirees

Wall Street's current bout of stomach-churning volatility is a vivid reminder of the danger of remaining fully invested in target date funds (TDFs) right up to your retirement date. If you're set to retire at a time when the market tanks significantly, you might have to delay your retirement, or you might be foreced to reduce your standard of living during retirement. Many older workers learned this lesson the hard way in the 2008-2009 stock market crash.

Most TDFs say they reduce your investing risk as you approach retirement. The key word here is "reduce," not "eliminate." However, the unspoken message that many workers hear is: "I don't need to think about investing because my target date fund takes care of that for me."

If you're more than 10 years away from retirement, that could be an appropriate response. But if you're within 10 years of retirement, you'll need to take a closer look at your investments and determine for yourself the appropriate percentage of your retirement savings invested in stocks.

Let's do some simple math to illustrate these ideas. According to a recent Morningstar report, the average allocation to equities for TDFs with 2015 to 2020 retirement dates ranges from 44 percent to 53 percent. The equity allocation for Vanguard's TDF fund series, one of the industry's largest, is 50 percent for a 2015 target date and 59 percent for a 2020 target date.

For the sake of simplicity, let's assume you're within five years of retirement and your TDF invests 50 percent of its assets in equities. A 50 percent drop in the stock market will produce roughly a 25 percent drop in your savings. Older workers invested in TDFs who were close to retirement in the 2008-2009 crash experienced declines of this magnitude.

Now, suppose you plan to use the 4 percent rule to generate a retirement paycheck (even though many argue that 4 percent isn't the "right" percentage). In this case, multiply the value of your savings at retirement by 4 percent to calculate the amount of your annual retirement paycheck. Divide by 12 to estimate your monthly paycheck.

Let's assume you have about $500,000 in retirement savings. In this case, applying the 4 percent rule results in an annual retirement paycheck of $20,000 ($1,667 per month) to supplement your Social Security benefits. If you experience a 25 percent decline in your savings just before retirement, you now have $375,000 in savings. This amount translates to an annual retirement paycheck of $15,000, a yearly drop of $5,000.

Note: Most older workers don't have anywhere close to $500,000 in savings, but that's a different -- and much greater -- problem for another day.

If you have other substantial sources of guaranteed retirement income, such as Social Security and a pension, it's possible that such a drop in your retirement paycheck wouldn't be a deal breaker for some people. But if you're like most folks, and you're really counting on that retirement paycheck to cover your essential expenses, losing $5,000 a year could cause a lot of pain.

So, what can you do? At the very least, understand the allocation to equities in your TDF, and determine if you can accept that level of risk. You might want to choose a TDF with an earlier retirement date that has a lower allocation to equities or move some savings into more conservatively invested funds.

Another strategy is to build a floor of guaranteed, lifetime retirement income that won't drop substantially when the stock market crashes. Such sources include Social Security, a pension (if you have one) and simple fixed-payout annuities you can buy with a portion your retirement savings (consider these to be "personal pensions").

Then invest the rest of your savings, and use systematic withdrawals to generate a retirement paycheck that covers your discretionary living expenses.

If you're within five to 10 years of retirement, you should start investigating and deploying this strategy now. If you need more guaranteed income than Social Security (and if you don't have a substantial pension) every year, you might consider buying small amounts of low-cost fixed-income annuities that start a guaranteed monthly paycheck when you retire. This way, you can "dollar-cost-average" as you purchase your personal pension in the period leading up to retirement.

Some 401(k) plans offer guaranteed lifetime withdrawal benefits (GLWBs) that protect your retirement income as you near retirement. In this case, you could consider moving a portion of your retirement savings into these accounts as retirement approaches.

If you don't pay attention to your retirement income strategy and asset allocation in this five- to 10-year period, your retirement "strategy" is no more than hoping the market doesn't drop just before you retire. If it does tank, you'll need to postpone your retirement or reduce your standard of living.

A thoughtful income strategy will let you look forward to your retirement years, rather than worry about them.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.