Several years ago, providers of 401(k) plans wanted to make the process of selecting a fund much easier. In doing so, they took a buy-and-hold methodology and added to that an age-based formula to develop new funds for 401(k) plans that would provide easy selection and a lifetime hands-off the steering wheel approach.
To select an appropriate fund (according to the designers) within the 401(k), a participant selects their intended retirement date, and then selects a fund that is close to that date. So if you plan to retire in the year 2015, the target date fund closest to that date would be heavily weighted in bonds. At the other extreme, if you plan to retire in the year 2045, the fund closest to that date would be heavily weighted in stocks. Both funds would hold stocks and bonds – the percentage allocated to each depends upon your desired retirement date.
This sounds good in theory, until you consider the fact that the bond market can decrease just like the stock market can decrease. And when both of these happen at the same time, it can be devastating to someone who is near retirement or in retirement.
Participation in these funds runs fairly high, and that makes the mutual fund companies very happy – since they only earn fees as long as you are invested.
The chart shows the historical record of interest rates, and it is quite obvious that interest rates are at extreme lows. When interest rates rise, the value of existing bonds decline. As we begin to approach the end of Quantitative Easing by the Fed, we have seen interest rates already begin to rise with just the anticipation of the end of QE. Once QE ends, interest rates are very likely to rise significantly higher.
How will this affect those who are near retirement or in retirement whose portfolio consists of a high percentage of bonds? It should be fairly obvious – they will lose a lot of money!
What could make it worse? A simultaneous declining stock market – so not only would they lose money from their bond positions, but from their mutual fund stock positions as well. This is what happened from 2007 to 2009.
If you are invested in target date funds in your 401(k) – whether you are in retirement, near retirement, or even if retirement is far away, a review of the options in your 401(k) is in order. Find an advisor who can help to select the best funds, sectors, and asset classes available within your 401(k). There is no need to see your hard earned money – and matches, decrease.
Chart source: dshort.com