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Efficient vs Effective Retirement Planning

| January 10, 2018
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In life we often have to choose between efficient and effective. Efficient is quicker and easier. Effective gets the job done, albeit with varying convenience. Let me give you an example. When you order clothes from Amazon you take a certain amount of risk. Think about it. How much can you really know about a shirt from several lines of description on your smart phone? Can you feel the way the fabric moves? Can you see yourself in the dressing room mirror? Is the color on your screen exactly the color in real life?

I've had mixed success ordering clothes online. The efficiency of staying in my bathrobe and doing all my shopping is quite enticing. However, when the shirt arrives it only fits as advertised about half the time for me. Then it's back to the UPS store to return it, which means the efficiency metric drops considerably when the fit is incorrect.

The solution would be "one-size-fits-all" smocks like the wore in the Middle Ages. What was once a sack of potatoes can efficiently and effectively be turned upside down. Add a few strategic holes for head and arms and my entire family has a shirt they can wear. On second thought, that's really not the look I was going for so scratch that.

You have the same dilemma when investing in your work retirement plan. The "one-size-fits-all" potato sack is the Target Date Fund. They originated to solve a problem in retirement plans at work. You see many people where having money come out of their paycheck to be invested into money market funds in their 401k. Plan administrators were concerned that participants were not going to have positive outcomes in the long term, and rightfully so.

The solution was to make a portfolio appropriate for each participant's age. A young participant would be heavily invested in stocks with some bonds. An older participant would be mostly bonds with a few stocks as part of the allocation. As the participant ages, the allocation tilts from stocks to bonds by percentage. On paper, the problem was solved. Especially, when Target Date funds became the default investment option for millions of 401k investors.

Here's the problem I have with this "one-size-fits-all" solution: it's efficient but not effective. There are several reasons, let me give you three:

1. Fixed-income (bond) mutual funds may not perform to expectations.
Currently rates are at historical lows. As rates rise, bonds lose value. In fact, many analysts feel we are the end of a 30-year bull market in bonds. If you own a bond outright, you may be able to weather the storm until your bond returns your money at par. However, in mutual funds you don't own the bond outright. You own the bonds mutually and you don't have the same return of your money at bond maturity.

2. There's no accounting for the individual participant's risk-tolerance or market outlook. Target date funds throw young people into the growth bucket and they through older folks into the conservative bucket simply based on age. In any other industry, this would be called ageism. In financial planning, we call it Modern Portfolio Theory. The allocations are based on historical characteristics of stocks and bonds and meant to lessen risk as you age. However, given the rising interest rate environment we discussed above, there's no sure thing in bonds. Furthermore, there 60-year old who have robust market outlooks and an appetite for volatility, just like there are Millennials with an allergy to it.

3. The fees can be high and hidden in proprietary Target Date fund of funds. Target date funds are usually constructed by combining several other mutual funds. So you'll see target dates funds with small-cap, large-cap and international equity funds. While fees have decreased and disclosure of fees have increased in Target Date funds over the last 20 years, they are not concerned with picking the best funds inside your Target Date fund. In fact, more often than not a mutual fund company will create a target date fund with only their in-house mutual funds. Is it the best fund in its category? Is it the most cost-effective? Those aren't questions that Wall Street is trying to answer. They want to gather and retain assets as efficiently as possible.

The solution to your Target Date fund dilemma would be to hire a Financial Haberdasher. In the world of shirts, a haberdasher creates custom measurements in the styles that make sense for your life. It's made just for you and fits you perfectly. As time marches on, fashions (and waistlines) change. You revisit your wardrobe and update accordingly. Likewise, a financial planner can help you create a retirement plan that makes sense for your life. If you'd like to learn more click here.

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