136- Why You Should Avoid Target Retirement Funds

In this episode Benjamin explains why these funds, despite often sounding very sophisticated and bespoke, are in fact a dead-end to financial independence. 

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Transcript

SPEAKER_00 0:12

Well, hello there, money nerds, and welcome to this episode one hundred and thirty-six of Heads Up on Money Design, Benjamin Mitchell. Thank you as always for joining me. It is great to have you with me. Let's get into this week's episode. It's going to be a bit of a shorter one. However, it was driven by a discussion I had with a client this week around the concept of target retirement funds or retirement dated funds. Going to get into what they mean in a moment and why you should be cautious and approach these with trepidation when it comes to your own financial planning. But before I get into the fun of this episode, it's a quick call out from me to say if you are enjoying Heads Up on Money and it is giving you any sort of value with your own financial planning, please do share it with your family and friends. Let's get more people feeling positive about their financial futures and feeling financially empowered. That's what we're all about here at Heads Up on Money. And if you haven't already, if I can ask one further favor from you, money nerds, would you mind leaving me a review if you're listening to this on Apple Podcasts? As it really helps boost the podcast up the money and finance charts. From the bottom of my heart, it really does mean so much. So anyway, how are we doing? We are racing through March unbelievably. How are you getting on with your end of tax year planning? It's a quick reminder that if you haven't already, then listen back to last Friday's episode where I did a little bit on your tax year end checklist, some of the things that you should be thinking about ahead of the end of the current tax year. Because with a lot of things in financial planning, it's use it or lose it, use that allowance, use that gifting exemption, use that capital gains tax exemption, pensions, ISAs, all the fun stuff. It matters quite a lot at this time of year because before we know it, we'll be into the 6th of April and the new 26-27 tax year, and many of the delightful juicy freebies that we had in 25-26 will be gone and we will be limited to the allowances we have next year. Now, of course, this stuff doesn't matter quite so much as the overarching asset classes that you're investing in and how much of your net disposable income you're allocating to equities every month, that is going to be the driver of long-term progress in your financial plan. But similarly, you do need to have an eye on tax planning when it comes to good financial planning because if you can optimize your tax situation simply, you keep more of your returns in your pocket. Less goes to the tax man, more goes into the bank of you for the future. So it's really important to be aware of these things. So anyway, I've tried to keep it fairly high level as always. If you listened back last week, 20 minutes of your life, that's all I'm asking of you. Episode 135, your tax year end checklist. Check it out now if you haven't already. But in this week's episode, we're talking about the danger of target retirement funds. Now this came up in a discussion I had with a client recently. We were looking at their workplace pension, and in that workplace pension, the current fund that they were invested in was named something to this effect, a target retirement fund or a target date fund. In their situation, it said the target date was 2038, which was the notional date that the pension scheme had of when that member was due to inverted commas retire. And it seems like a pretty good option because you think, hey, they know when I want to retire. That matches broadly when I would like to retire. So surely that can only be a good thing. We kind of get that false association that we think the pension scheme knows our situation and knows our financial picture. But the reality is they don't, and I never encourage my clients to go into these sorts of funds. They are a total false sense of security and can actually be incredibly detrimental and incredibly damaging to your long-term financial health. And I'm going to explain why in this week's episode. So target retirement funds, let's let's strip this back and apply the principles that often happen around these things. So you join a workplace pension scheme, for instance, or you may have these funds accessible in a private pension that's available to you. Similar principles principles apply. But if we work on a basis of a workplace pension, is as I talked about before, when you join a new employer, subject to the rules of auto-enrollment, you will be enrolled into a workplace pension. And you get that false sense of security because you assume that someone somewhere is looking after your pension for you. Or you join your new workplace and they will tell you you've been enrolled into the pension, and you assume, yeah, you're probably going to be in quite a good fund because your employer has set this up for you. Then my employer is going to have my back when it comes to my retirement plan. Now I'm not discrediting and disparaging every employer out there, but most employers have absolutely no idea what exactly is meant by good financial planning, and HR departments will have no idea and no interest in your own retirement planning journey. So typically what happens is you will be enrolled in an average fund, a typical middle-of-the-road fund, which may just be, you know, as simple as a moderate fund or a balanced fund. The terminology differs depending upon the pension provider, but generally speaking, you're in a pretty plain, pretty vanilla fund that will probably have reasonable to perhaps aggressive charging in some cases. Sometimes it can be favorable charging, don't get me wrong, some workplace pensions are very cost efficient, but generally these funds will be crap. Let's just call it that money nerds. They're going to offer little in the way of long-term capital growth. And it is one of the most detrimental elements of financial planning is the fact that new employees, you know, someone who's in their early to mid-twenties, joining a workplace pension for the first time, they are thrown into one of these funds with potentially 30 to 40 years of investment growth ahead of them. And they sit in this average fund, which has too defensive an allocation to defensive securities, for instance bonds, and not enough allocation to the great companies of the world and the powerhouse of investment returns and leveraging stock markets that is done through equity investing. And you're not really aware of the fund you're in because you assume your employer has your back. And if your employer doesn't have your back, then surely the pension provider will have my back. Someone is taking ownership of this. That's the belief we have. But the reality, and as we know now, money nerds, is you have to take control of your own financial future. And quite often, most people will sit for the entirety of their careers languishing in this middle-of-the-road fund and review it whether that's themselves or with a financial professional, when they're in their mid-50s and they've got very little time on their side and they've missed out on multi-decades of investment, growth, and compounding. So that's the flaw of when you join a workplace pension. Where it relates to today's topic is quite often when you join a workplace pension, they will have a preconceived idea or a preconceived notion of when you plan to. Inverted commas, you can't see me doing it on the podcast, but I am using the inverted commas sign here, you can probably hear through the microphone, of when you want to retire. And they will use a fairly arbitrary number. Often it will be 60, 65, 65 is a common one, it might be the state pension age matched to state pension age being 67 typically at the moment, and they have this idea of when Joe Bloggs or Jane Bloggs is planning to retire. And where do they get that information? It's probably something you may have selected at the outset or your employer might have done at the outset, who knows, but it is guff. It has no bearing on when you actually plan to retire. They have no oversight of your financial plan. Only you do money nerds or a financial professional if you're working with them. And where target retirement funds come in is one of the funds that you may be enrolled into at the outset will be one of these target date funds or a target retirement fund. And if for instance you were planning to retire in the year 2050, that was when let's say you are 65, then they will apply a target date fund, perhaps called something along the effects of you know target target date 2050. That might be the name of the fund you are in. And again, issue number one is that date is arbitrary. That is not to say that is the date when you plan to retire. And if it even is the date you plan to retire, it's a grossly outdated concept. Because as you know by now, money nerds, the way that pensions typically worked in the past, before we came to the current pension landscape being flexible drawdown of pensions, was we built up our pension pot, and when we get to that date of retirement, we use that pension pot, we take a tax-free cash, we get our lump sum, and we buy a boat, we buy a car, we pay off the mortgage, we put a garage extension on, and with the remaining pot, the other 75%, we buy what something is called an annuity. And an annuity is basically a guaranteed income for life. So we hand over three-quarters of our pension pot to an annuity provider and they give us a guaranteed income for life. Now, annuities can be useful for some people if they've got limited guaranteed income in retirement or they have no children that they wish to pass pensions pots to in the future, if they've got a very defensive attitude to risk and very low capacity for loss, so that they cannot afford to have volatility short-term volatility, remember, in the value of their pensions or their investments, so they need that guaranteed income. So annuities can be beneficial. I'm not here to kill the annuity dream in this episode, although I rarely do recommend them for clients, it's another story. But the idea behind this, as I said, is that in the retirement date of old and the retirement age of old, is we would want to de-risk our pots, our portfolios, gradually over time so that when it comes to the date of our 65th birthday or 2050 in this year, in this example, we would use our pot to buy an annuity, and we don't want to have too much volatility and the value as we get close to 65. So that makes sense intuitively, and this is where these retirement date funds or target date funds come into effect, is they will typically water down the whiskey, think of it as that analogy, of your pension fund as you age and as you get closer to this arbitrary retirement date in the future, in this case 2050. And the way they will do that is in the earlier years of your growth journey, you will have a greater allocation to equities, companies, shares, great companies of the world, innovation and ingenuity now and in the future. That's all that stock market investing is in companies. And they will blend that with more defensive securities, labeled defensive, but in reality, you know by now the greatest risk to the long-term wealth creation of your financial plan and your financial futures is being too defensive, is having too high a concentration to things like bonds and equities. If you want to improve your financial future, make tomorrow more profitable for you than it is today, you need to own, not loan. I'll repeat that, you need to own the companies you're invested in, not loan them, which is what bonds are. Yes, bonds are paid first in the order of priority if a company was to go under, but if you're diversifying appropriately across companies, across sectors, then you are not having all your eggs in one basket. You are simply leveraging the power of global compound returns via the global stock market. Again, talked about this endlessly in other episodes of the podcast. But the premise is as you age, more and more of your whiskey, your equities, will be watered down by bonds, government bonds, corporate bonds, maybe in a blending to cash or other defensive securities that will be increased as you age so that there's less volatility short term in the value of your pot. And we tend to think this is a good thing. We think this is great because they know when we want to retire in theory. It sounds like they've got a bit of knowledge on us, we've got someone looking out for us, and yeah, why would I want to have too much risk in my pot when it comes to the point when I plan to rely upon it? But as we know by now, money nerds, when you get to retirement, when you get to 65 in this case, you hopefully still have a long investment time frame ahead of you. And a lot of these target retirement funds or target date strategies are blending out the equities at an incredibly early juncture. Typically, you can see from 15 to 20 years away from retirement, you're starting to water down this whiskey. And all you're doing there is limiting your ability for long-term capital growth in the years where it might matter so, so much. And we're sleepwalking into this. We are not educated about the dangers and the perils of these funds. We are thrown into them at the outset of joining a workplace pension scheme and we think that's it, we are sorted. And quite often, because these funds have a bit more of a manual intervention from the fund manager, in that there is that tailoring back of the equities in favour of bonds as you advance in age, often they will have slightly higher management fees to compensate the manager for administering that. So not only are you leaving returns on the table compared with a simple globally diversified tracker portfolio, you are also potentially paying more to the fund managers for the privilege. So there's a double whammy, a double drag on your performance. So just to reiterate, why are these things damaging? They're damaging because as we get to retirement, the benefits and the things that have served us well, investing in global equities and invest and forget that those principles do not abandon us when we get to retirement. We should still be leveraging the power of global markets. And when we're at retirement, we should not be sitting with our pension pot solely invested in bonds and cash. That is investment suicide and is the only way to guarantee yourself a poverty stricken retirement. Yes, if you're planning to buy an annuity, it can be beneficial. But similarly, do you really want to be putting all your eggs in the basket of assuming you're going to buy an annuity in the future? What happens if your situation changes? What happens if your objectives change? So let's just recap. Why are these funds so dangerous? Well, they appear to be a one size fits all, but they're really not. The fund assumes everyone retiring in the same year, and they should all have the same investment mix. In reality, people differ in our risk tolerances. Some of us have a greater appetite for risk, some of us less, some of us wish to invest in equities beyond the concentration that these fund managers apply. They are basically equivalent to a suit being picked off the peg. When it comes to your retirement plan, you want it to be bespoke, you want it to be a custom-made suit, don't you? And as I mentioned, higher fees, hidden fees in many cases, the path towards retirement will be far too conservative for most people. Do you really want to be increasing your allocation to bonds when you're in your late thirties? I would never recommend a client does that, so why do these funds recommend it? And also, the danger with these sorts of funds is I think they give you too much of a set and forget false sense of security. As you assume, as I've said, that the fund is looking after your retirement plan. There's something going on behind the scenes, we have this false sense of security that when we get to retirement date, we're going to have this lovely guaranteed income that's going to be paid to us. We all need to wake up, we all need to smell the retirement plan in coffee, folks, because that is not the case. You're in for a nasty shock if you think one of these funds is going to get you from financial dependence to financial independence. So you need to be taking ownership of this. And obviously, there's just a lacking flexibility. You can't customize this to your own wishes. You can't increase the allocation, you can't decrease the allocation to equities. You're basically stuck in this investment mix, and it often will not be suitable for anyone. And because they are trying to make it applicable for everyone, it's one of those weird things is that it actually benefits no one. So my word of warning to you, money nerds, is if you see these retirement-dated funds and you see something that says target date of 2055, and you think, you know what, that's probably when I would be wanting to retire. Surely that's a good thing. Approach it with caution. Again, if something seems over-engineered and too good to be true when it comes to financial planning, then it often is. Simplicity wins out. The best investors and the most financially independent people are those that recognise this early on. And you, money nerds, listening to Heads Up on Money every week, should recognize this by now. That you do not need to reinvent the wheel to do well with your financial planning. And target retirement funds are just one example of something that would not be invented again today if it didn't exist now. It is a product of marketing by fund managers, not necessity by end investors. So I'll leave that with you. Reflect on this, be hesitant when you see them. Again, go for a simple route, money nerds. Recognize that equity investing is the key to long-term success, and when you retire, the foundations of that do not so no longer apply. You still need to be leveraging the power of the stock market. Yes, there are certain things you should be doing differently in retirement, such as increasing your allocation to shorter term cash by having a nice buffer set aside should the inevitable market crashes occur early on in your retirement journey. But aside from that, the foundations still apply. Target retirement funds have no place in my retirement plan, and they have no place in your retirement plan, money nerds. So I hope that was helpful. I'm going to wrap this one up in under 20 minutes, climbing down off my soapbox, take a breather, give you a bit of your weekend back. Thank you as always for joining me. I hope you found that episode helpful. If anybody you know is considering this or has just joined their employer, a new employer, and they're looking at the funds they're invested in, send this to them because making this tweak early on could potentially make thousands of pounds of a difference in the future with the compounding effect of growth and wealth over time. I've been Benjamin Mitchell, you've been the Money Nerds. Thank you as always for joining me on Heads Up on Money. I'll catch you next week, next Friday for episode 137. Until then, stay safe out there and have a great weekend. Goodbye for now.