Target date funds are popular for many 401(k) plan participants because they offer an investment strategy that automatically reduces risk as one approaches retirement. They’re especially effective for investors who don’t want to self-manage their retirement assets and younger investors under 50. Further, target date funds align with the needs of most credit union employees, who will generally rely on their 401(k) for income during their retirement. 

However, credit union executives generally have more resources and benefits than the average employee, each with different distribution frequencies, that they may utilize after retirement. In the latest “C.U. On the Show,” Doug explains why target date funds are a suboptimal solution for credit union executives supported by the newest ACT white paper, “Target Date Funds: The Wrong Investment Vehicle for Many Credit Union Executives.” He further discusses the significant financial difference credit union leaders may experience with a case study illustrating three scenarios of a typical executive.

Case Study Examples

A key concept of target date funds is that risk is automatically decreased as you near your retirement date because, in theory, you will use those funds as soon as you retire. This may be true for most credit union employees, however, it can create far too conservative of an approach for credit union executives. Most credit union executives will have far more resources on their retirement date, which may include their final paycheck, bonuses, 457(b), collateral split-dollar plan, and accrued annual and sick leave. This means that most credit union executives will not consume their 401(k) assets on their retirement date, but in some cases, not until almost a decade later. If this is correct, the executive may miss out on a period of saving at a higher risk level and accumulating even more assets if they’re using a target date fund.

Using three example scenarios, Doug explains how risk and the consumption date, not retirement date, factor into an executive’s ability to save more and their probability of sustaining their assets through retirement.

  • Example #1 Traditional Use of Target Date Fund: In this first scenario, the executive’s target date fund is utilized as intended, based on their retirement date.
  • Example #2 Aligning a Target Date Fund with Consumption Date: In this next scenario, the executive continues to use a target date fund but chooses a date based on when they’ll consume their 401(k) assets.
  • Example #3 Retirement Plan Customized Around Risk and Consumption: In the final example, the executive designs a custom plan that integrates varying risk levels and the consumption dates of the various retirement income sources available.

Stream the episode to learn which plan performed best and how executives can improve their retirement planning approach for their most effective financial gain.

Audio Transcription (pulled from the podcast)

Doug  (00:00)
Hi, this is Doug English. Today, I am not only the host of “CU on the Show”, but I am the guest here to talk to you about why target date funds are the wrong investment vehicle for many, if not most credit union executives.Target date funds have been a widely used option for a long time, they’re popular, because they’re really easy. They offer the investor an entire portfolio in one fund, and that fund becomes more conservative over time. So, you don’t have to worry about picking an international fund and a small cap fund and a Balanced Fund, you have to worry about picking any of that. For most participants about 80% of credit union 401k participants have all or some of their savings in a target date fund. Now these tools work really well for normal credit union employees because it just gets it done in a single step. And instead of that employee going back to work and forgetting about their investment approach, the investment approach is handled for them. However, they’re one size fits all approach that target date fund for the year 2040 is exactly the same for a senior executive as it is for any other person that’s in the target date fund. And what we’re going to talk about today is why that is a substantially sub optimal solution for credit union executives. 

Doug  (01:39)
A key feature of target date funds is the concept that the investor will begin utilizing the money in the account shortly after their chosen date. Now, credit union executives typically have more than one source of income beyond the 401k. The way that usually works, is the year that the credit union executive retires, they’ve got their final paycheck, they’ve got the bonus from the previous year, and they’ve got annual leave and sick leave. So, they don’t usually need any money in that first year, then the collateral assignment split dollar plan starts paying in the 457b plan is usually also spent at that point in time. And each one of those is going to get most credit union executives through the first two or three years of retirement. Then we often see that the collateral assignment plan, between that and the investments leftover from the cash distributions that I just mentioned, most executives are not consuming their 401k until age 72, when they are forced to take required minimum distributions. So, target date funds that are aligned with a credit union executives retirement date are invested way too conservatively for the actual expected consumption of these assets. Now the allocations of target date funds are pretty appropriate for younger investors. But they get a bit too conservative for those over 50, particularly credit union executives that have these additional plans. 

Doug  (03:26)
In our white paper on target date funds, we lay out a case study for Bob and Jill. Bob is a 50-year-old credit union CEO and has a typical compensation package for a middle market credit union CEO. He plans to retire at age 62, has a 457b, has a collateral assignment, and has a 401k and max funds it. So, what we do is to lay out all the facts and take a look to see how Bob will do with a traditional use of a target date fund. And then we test to see how much better it would be if Bob used a target date fund that was aligned with the consumption of his money, not with his retirement date. And it makes it substantially better. Then we say what if Bob had a custom design that decreased in risk according to the specific personal plan consumption of his funds, and of course, that is where Bob gets the best outcome. 

Doug  (04:39)
So, we modeled the gradual reduction of risk in his account in five-year increments. So, the target date fund starts with a 67% equity concentration that decreases to 61% in retirement, and then 30% at age 71. So that’s the glide path of the target date fund. That’s one of the things that folks love about them is that they automatically get more conservative. Well, if our example Bob uses that target date fund that is aligned with his retirement date, our analysis shows he’s actually not going to need any money for about 10 years—going to retire at 62 not going to need to take any money out of the 401k until 71. So, if he uses the target date fund, we run a statistical analysis on his portfolio to say, how likely is it that Bob runs out of money, well it’s not very likely. Bob results in a 80% confidence level that he’s going to have enough money for retirement using the target date fund in the traditional way, with a median asset value at the end of Bob’s life expectancy of $620,000. So it gets there, right, it works, but it can be done ever so much better. 

Doug  (06:03)
So, a reminder in Bob’s scenario, we have calculated that he will not actually need any money until age 71. So, we assume, instead of aligning his target date fund with his retirement, he changes and uses a 2045 fund that’s aligned with the initial consumption of his 401k. So that allocation within that fund begins with an 85% equity concentration at his age 50. That decreases down to 64% by the time he reaches retirement, and bottoms out at 30% equities when he gets to age 83. Now we keep all the other variables in our case constant. And we check again to say, what are the chances that Bob has enough money? We run our Monte Carlo analysis on 1000 different trials to say, what are the chances that Bob has enough money, we have now taken his level of financial security from 80% confidence level to 89% confidence level. We’ve taken his expected median asset value from approximately $600,000 to $1.1 million. So, the credit union executive with the same resources planning to spend money in the same way at the same time, by aligning their target date fund, with their actual date of consumption, our illustration, doubles the financial resources available to Bob and his family. 

Doug  (07:01)
Finally, in our final scenario, we will examine the effect of personal custom dynamic risk changes. And in this scenario, we assume that at age 50, Bob is invested in a 90/10 stock bond mix. Now you might think that sounds awfully aggressive. But remember, Bob’s 401k is important, a critical asset, but the majority of his income is actually coming from his collateral assignment split dollar plan. So, he can afford to be more aggressive than average because he has more resources than average. That risk level is reduced over time, as he approaches the projected consumption date of 71. Moving to an 80% stock 20% bond mix at retirement when he’s not yet spending it, then to 60% stocks at age 68 and 50/50, when he actually starts to spend the money at age 71. Now the effect of doing that takes the confidence from our Monte Carlo simulation up from 80% the first time we ran it, and then got better got to 89% the second time we ran by just making the target date fund aligned with his consumption. And by now making his risk level cost him to his actual personal dates of consumption, we can take that Monte Carlo level up to 95%. No change in resources, no change in spending. But now he’s gone from an 80% confidence level to a 95% confidence level. From an expected terminal value of the assets to his family of 600,000 when we aligned it with his consumption, it was 1.1 million. When we align it with his actual life plan, it’s 2.2 million. So, we are approaching a 4x impact from Credit Union executives, not just selecting the target date fund that aligns with their retirement date. But designing a custom risk profile that steps down according to what your resources are and when you’re going to spend those assets.

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