A New Role for Stocks in Retirement Funds?

Before bailing on stocks, consider overall retirement risks and build the right retirement plan.

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The stock market—and retirement accounts—are slowly recovering some of the horrendous losses inflicted in 2008 and early 2009. No one knows how many years it will take before investment values claw their way back to the level of the fall of 2007. But what is clear is that stocks will lead the way up, as surely as they led the collapse. What's also clear is that many investors have been warned away from retirement funds with heavy stock weightings.

Target-date mutual funds, which are designed to produce optimal returns based on a planned retirement date, have taken a sustained drubbing from many consumer advocates who have testified on Capitol Hill and from more than a few investment experts. The funds hold a mix of stocks, bonds, and money-market instruments and automatically adjust the percentages of such holdings as investors near retirement. This is known as a "glide path." When such funds designed for people reaching retirement age in 2010 lost 25 percent of their value last year, it came as a shock—especially to those who thought funds designed for people retiring soon should have been much less heavily invested in stocks.

[See Target-Date Funds Finally Showing Solid Gains.]

Critics of target-date funds have urged more disclosure, a more conservative investment mix, and even the development of a new generation of government-mandated retirement funds with very conservative return goals. Some of this may come to pass, but it would be a classic legislative and regulatory error to protect investors from the crisis already past. The fact is, many—if not most—retirees simply cannot achieve their financial goals without holdings that include a lot of stocks.

Target-date funds have become increasingly popular since a 2006 law encouraged employers to offer "automatic pilot" default choices in their retirement plans. Ibbotson Associates, a unit of Morningstar, tracks the performance of more than 310 target-date funds that have been around for at least a year. During the second quarter, this category posted its first gain after six straight quarterly losses. And it was a healthy 15.5 percent bump, nearly matching the S&P 500 index's gain of 15.9 percent (and remember, the S&P 500 is purely stocks). As of June 30, those 310-plus funds had nearly $200 billion in assets, and that amount is expected to rise as the economy recovers, markets presumably do the same, and contributions to retirement plans regain their footing (including the resumption of many postponed employer matches).

Reducing the stock component of these funds may reduce the risk of short-term market losses, but it also will drastically increase the risk that investors will fail to meet their retirement goals. Perhaps the so-called experts simply forgot to communicate and educate investors about the value of stocks. The market was going up for everyone, and no one was much looking at where the gains were coming from. When things turned around and the investment heroes became bums, the historic role of stocks became lost. So did the equally fundamental understanding that all investments carry risks and that there are different types of risk that investors should consider.

[See Target-Date Fund Expense Fees Vary Wildly.]

When the dust from last year's collapse and attendant finger-pointing has settled, it will be clear that nearly everyone in the process needs a much better understanding of these risks, especially as they effect retirement investments. There is short-term market risk. Painfully, we have seen that. There is also asset-class and industry risk. Even in good economies, investment experts can make the wrong call on which assets, industries, and companies to back. There's inflation risk, which should be a big concern for investors these days. The federal deficit may approach $2 trillion this fiscal year, and the deficit is now larger, as a percentage of economic activity, than at any time since World War II. Lastly, there is longevity risk. How long will you live, and what is the risk that you'll outlive your assets? Target-date funds are designed to address all of these risks, but few critics looked beyond short-term market risk when they assessed industry performance.

Overall, the real question is not whether the glide paths of target-date funds are too aggressively weighted toward stocks. It's whether the risk profile of a fund's glide path is appropriate to a single investor. Should you be in funds that have 60 percent of their holdings in equities today and only 50 or 40 percent in 10 years? Or should it be 70 percent now and 55 percent in 10 years? Should you adhere to the common wisdom of many investment advisers that the percentage of your retirement investments held in bonds and other conservative holdings should equal your age? If you follow that advice, your stock-bond split would differ sharply from nearly every target-date fund out there. Who is right?

Again, the only right that matters is what's right for you. There are some excellent online tools that can help you figure out the best glide path. It depends on a lot more than your age. Tom Idzorek, Ibbotson's chief investment officer and director of research, says he likes to spin a counterintuitive tale to help people understand that their tolerances for risk aren't always what they seem. He tells the story of two retirement investors—a high-flying hedge-fund manager on Wall Street and a tenured university professor. Mr. Hedge Fund makes a lot of money, the professor a comfortable but immensely smaller amount. The hedge-fund guy is 40, the professor is 55. Who should have the safer retirement portfolio? Well, as Idzorek explains it, the hedge-fund manager clearly should take the more conservative approach to his retirement funds. Yes, he has made a lot of money, but his industry is in a shambles and his earnings outlook and stability are lousy. The tenured professor, on the other hand, might not even have to show up for class to continue getting paid for the rest of his life, and he probably has a sweet annuity deal from TIAA-CREF. He can, and should, adopt a much more aggressive investment posture with his discretionary retirement money.

Of course, we don't know how much wealth our two hypothetical investors hold, the scale of their family obligations, or whether they have serious health problems. In short, there are lots of things that can affect your risk profile. The good news is that you know about all of them.

Vanguard has an interactive investor questionnaire to help you get a general idea of the equity-bond split you should have in your portfolio. Change your answers to see how it affects the splits produced by the tool. You might enter different sets of assumptions and ages and build your own glide path. Once you've done that, Morningstar has a great Asset Allocator tool to help you understand the likelihood that you will reach your retirement goals. If you're a paid subscriber to Morningstar, you'll find it under the "tools" menu. If you're not, T. Rowe Price has a free version of the tool, but you'll need to complete a registration to use the site. It's worth the effort.

Here's how it works: Enter the current value of retirement accounts, add any monthly retirement savings to this amount, and then select the years until your retirement on a sliding scale that appears on the screen. Next, you can enter the amount of money that you would like to have when you retire—either as a lump sum or as an annual payment for however many years you specify. Finally, you can choose the composition of your portfolio. Morningstar has created preset aggressive, moderate, and conservative asset mixes, but you can choose your own by selecting percentage weights from among five asset classes—cash, bonds, large capitalization stocks, mid- and small-capitalization stocks, and foreign stocks. As you're doing all these things, the interactive tool will redraw a graph showing the growth of your nest egg over time and present the odds, in percentage form, that you will reach your goal. Helpfully, the tool also shows you the odds of reaching smaller percentages of your goal. As you change the risk components of your portfolio, you'll be able to see how the odds change that you'll reach your goals. It can be a humbling experience, but shifting the variables is a real eye-opener about how much risk you may need to take.

Odds are, you'll end up with a portfolio that contains a lot of stocks.