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Bloomberg: Why a ‘fatal flaw’ in retirement plans could be exposed

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A law enacted in 2006 — the Pension Protection Act — allowed companies to roll their employees into a 401K retirement plan, with many of those plans being target date funds (TDFs) which are based on the premise that risk should be reduced as a plan-holder grows older. Now, certain cracks in this system are beginning to show because of the current high-inflation environment, according to an analysis by economist Allison Schrager published by Bloomberg.

While a group of economists studying these plans with data from 2006-2018 determined that the trend toward enrollment in such plans was a partial success in terms of getting more people to participate in retirement planning, certain shortcomings also became apparent.

“TDFs are a good strategy while you are in the saving phase of your life,” Schrager explains. “But they have a crucial weakness that stems from what financial economists call the fallacy of time diversification, or the flawed idea that the longer you invest in markets, the less risky they are. The logic follows that if you are closer to retirement, stocks are riskier because you have fewer years ahead to reap gains or recover from losses. Therefore, you should reduce your market exposure.”

TDFs move savers into shorter-term bonds instead of functionally providing retirement income with a duration of around five years around the age of retirement, the article explains. This can be a good strategy for anyone whose goal is to avoid losing money due to market volatility, but is not optimal if the purpose is to spend from sustainable funds in retirement.

“When you reach retirement, you will probably need to finance about 15 to 20 years of spending between you and your spouse,” Schrager writes. “But if you invest in short-term bonds and stocks — TDFs have increased stock exposure for all ages in the last 10 years — you will face a lot of risk because the bonds chosen by TDFs don’t provide much inflation protection (inflation-protected bonds are a tiny part of the bond portfolio). If inflation continues to go up and interest rates rise (decreasing the value of your bond investments), you will fall even further behind.”

This is particularly troublesome for current retirees who are leaving the workforce amid an environment of high inflation and rising living costs, the article says.

“Americans are retiring in a high-inflation environment, with unclear guidance on how to spend their nest egg while stuck in an investment strategy that doesn’t help them preserve income,” Schrager writes. “Their spending will fluctuate year-to-year as the stock market and interest rates rise and fall, and they may experience declines in living standards as they age.”

Read the article at Bloomberg.