I experienced “sticker shock” this year when I reserved a car to use in Maine for my summer vacation. The cost for the exact same car I have rented in previous years was exactly 50 percent higher than last year. Checking with other rental companies left me equally stunned.
So inflation, whether prompted by demand (which is probably the case with vacation rental cars) or cost-push inflation (which will result from higher minimum wage laws), will mean that broad exposure to increased costs is undoubtedly on its way.
So what constitutes one of the better antidotes to inflation for those approaching retirement or already there? Looking at target-date funds offers a glimpse of what professionals feel is an effective segue from stocks to progressively larger holdings of bonds over time. Target-date funds are those that assume that the investor will be retiring as of a specific year. These funds are now by far the most popular investment in 401(k) plans. But do their managers know what they’re doing?
Someone retiring fourteen years from now, in 2030, would find themselves in a target fund with about 45 percent in domestic stocks, 30 percent in foreign stocks and 25 percent in bonds. In target-date funds for 2040, 2050 and 2060, the percentages don’t vary much — about 53, 37 and 10 respectively for all three retirement dates.
I don’t have a bone to pick with the allocation of international/foreign stocks, because a number of studies indicate that there is inverse correlation between domestic and foreign stocks. Just comparing returns over the past 11 years between these two fund classes, a 500 index and an international growth fund, will show that the average annual return for each was about 8 percent, but the year-by-year returns for the two combined had far less volatility. When one was up, the other was down, and the return of both combined looked more like a straight line — the path of minimum regret. So that concept made sense.
What didn’t make sense was the early allocation to bonds. Why do the managers have at least 10 percent of the money in bonds for people who are 44 years away from retirement (target 2060)? Even the target 2040 had the same complement of bonds for an investor who could look forward to experiencing at least four or five stock market cycles over 24 years. To let money languish in a bond fund earning what has been about 6 percent per year versus the 8 percent in stocks over the past eleven years is just a waste of money. Setting aside this recent history, stocks typically earn 10 percent and bonds about 5 percent. If you do the math, the difference in reduced expected return after dragging along just that 10 percent in bonds costs the whole portfolio about a half percent per year. It doesn’t sound like much until you realize that on, say, $1,000 per month in contributions, the difference adds up to $150,000 in 34 years.
It’s worse for a couple who buys a typical target-date 2030 fund, which calls it quits in just 14 years. That fund will have 25 percent in bonds, so the quarter of the fund in bonds earning 5 percent will drag what would have been an all-stock 10 percent return down to 8.75 percent. For a couple 14 years from retirement with, say, $300,000 today and contributing $1,000 per month, the all-stock return at 10 percent will accumulate to a total of $1,492,000. Dragging the bonds along will drop the return to 8.75 percent and compound to just $1,291,000 — a $200,000 cost for something that is of questionable value.
The problem with these target-date funds is that they are robotic. They make a lot of money for the fund industry, which can charge far more than a simple service of questionable value may be worth. With equity in a home satisfying the bond component of the big picture, a couple may be far better off allocating contributions from now until retirement totally to stocks and just hedge the bet by choosing stocks or stock funds that pay hefty dividends. The increasing dividends may not keep pace with the cost of renting a car or chomping into a Big Mac, but at least they will offer more protection than all those bonds in a target fund.