Make sure you’re not off Target
Target date funds have become popular over the past 15 years after Congress passed the Pension Protection Act of 2006. These funds are investment vehicles which invest their assets in other mutual funds which include both passive and active portfolio management. The purpose behind these funds is to provide a long-term portfolio allocation for the unsophisticated or “autopilot” investor. Retirement savers are meant to park their hard-earned money into one fund which generally matches their retirement year. As time progresses, the overall allocation gradually shifts from a dependency on equities to bonds so it becomes more conservative and less risky as the “target date” approaches. The retirement saver may be preparing to live off of the overall portfolio, if needed, but that should be a separate conversation with your wealth advisor after an appropriate cash flow analysis to see what income gaps may need to be filled.
A few concerns with target date funds which need to be considered for the retirement saver are accountability, fees, and the inability to control capital gain distributions.
Target date funds typically do not invest directly into equity or bonds but in underlying pooled investments such as actively or passively managed mutual funds and exchanged traded funds (ETFs). A large portion of these target date funds invest within the same fund families and are not punished for underperformance by withdrawing their money. For example, an American Funds target date fund would invest only into an American Funds passive or active fund.
Investment managers who spearhead longer range target date funds, such as 2060, may also feel more inclined to take more or unnecessary risk if short term performance is not a priority for them. Active portfolio managers, such as ACM, not only look at long term investment opportunities but also recognize where the state of the current economy is and how current holdings can provide strong performance in the short term based on rising interest rates, rising inflation, etc.
Retirement savers may believe target date funds are similarly priced to index funds or passively managed mutual funds with expenses below 0.05%. This is a common misconception as some target date funds are layered with fees. Not only do they charge an internal expense fee to manage their own fund but long-term investors should be conscious of the additional fees which stem from the individual funds the target date fund holds. For example, the American Funds 2030 R-6 fund (RFETX) has an expense ratio of 0.33% and includes funds such as the AMCAP fund (RAFGX) which has an additional expense of 0.34%. As you can see, these layered fees add up and decrease the long-term performance for retirement savers. There are typically no internal expenses or layered fees at ACM since we primarily own individual companies through our custom stock and bond portfolios.
Last but not least, capital gain distributions are an unfortunate and unforeseen tax event which should be on retirement savers radars. Generally speaking, mutual funds are tax inefficient because you’re paying into the fund’s cost basis versus owning specific securities outright.
For example, when buying into a Vanguard mutual fund which owns Apple stock, you’re buying the fund’s cost basis in Apple, which could own shares it purchased going back many years when the stock price was much lower. If purchase an equity mutual fund in January 2021, you could unexpectedly end up paying a huge capital gain tax in December 2021 from the fund owning that security for 10+ years. You wouldn’t be able to control that tax liability. You have more control when you own individual stocks and bonds at your own tax basis.
Vanguard’s Target Retirement 2035 and 2040 funds paid out roughly 15% of their total assets as capital gains which are taxable outside of retirement accounts. I’ve worked with investors who experienced $200k-$300k worth of capital gain distributions in a single year on top of their earned income, social security, pension and other sources of taxable income. A portion of the capital gain distribution may be treated as short term or long term which could kick them into a higher tax bracket. Or the unexpected, unwanted capital gains could increase your earnings for Medicare premium purposes, resulting in an increase in Part B and Part D premiums two years later.
Retirement savers nearing retirement should be conscious of how tax events such as capital gain distributions will affect other aspects of their financial situation. If you have any questions about your current 401(k) allocation or how to manage your outside retirement funds, please do not hesitate to contact your ACM Wealth Advisor.
*Editor’s Note: It has been brought to our attention since this article was published on 01/24/2022 that the Attorney General of Massachusetts, Mr. William Galvin, is opening an investigation into some of the biggest fund families on this topic. Companies such as Vanguard and American Funds (which is referenced) are being summoned to respond to Mr. Galvin and investors. This may be a domino affect amongst the states and needs to be on retirement savers radar. Please see the referenced article from financial-planning.com below:
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