Baby Boomer Jeopardy In Target Date Funds

·       Baby boomers in target date funds (TDFs) face a 40% chance of loss in the next 5 years.

·       Sequence of Return Risk peaks in the Risk Zone spanning the 5 years before and after retirement. Most baby boomers are currently in the Risk Zone.

·       Most TDFs are at high risk at the target date, but a few, like the $Trillion Federal Thrift Savings Plan, offer about half the risk.

·       With stock markets at historically high valuations, the probability  of a correction is elevated, making reliance on luck a poor strategy.

In the 1971 hit movie Dirty Harry, Clint Eastwood points his .44 Magnum – the most powerful handgun in the world – at the bad guy and asks: “Do you feel lucky today, punk?” In this article, I explain why baby boomers in target date funds (TDFs) should not feel lucky today or for the near future.

The odds are not good that baby boomers in TDFs will complete this decade without experiencing an investment loss . The next 5 years are critical because that’s when Sequence of Return Risk peaks, although baby boomers are not worried because they don’t know – they feel lucky today. 60% of our 70 million baby boomers are currently in the Retirement Risk Zone that spans 5 years before and after retirement.

Here are the odds that baby boomers will not be lucky. See the detailed table in the next section. There’s a 40% chance that the typical TDF will have at least one losing year during the next 5 years. Statistics don’t tell us how bad that loss might be, but Jeremy Grantham and others believe it will be shocking. These are bad odds, especially since retirement with dignity is at stake.

But not all TDFs are “typical.” A few that are much safer have only a 20% chance of losing money in this decade – about half the risk in typical TDFs. In the following, I provide the math that estimates the probability of loss in TDFs for these 2 groups of TDFs – Safe and Risky (typical). The Risky group has won the performance horserace over the past 18 years, but that will change as stock prices reach unprecedented levels and luck runs out.

Two Groups of TDFs – Risky and Safe

Most TDFs are the same. They are at high risk at their target date. But a few are very safe, most notable among them is the $Trillion Federal Thrift Savings Plan, the largest savings plan in the world. Here are the differences:

A return below zero is 1.27 standard deviations – 10% probability -- below the mean for the typical TDF, and 2.17 standard deviations  – 5% probability -  for the Safe group. If we expand these annual probabilities out to the 5 years that end this decade, there is a 40% chance of losing money in the typical TDF, but only 20% in the safe group.

Here are the details of the probability of loss in one year and five years.

Due for a Correction

The conditional probability of loss is even higher because the US stock market is currently very expensive – more than 3 standard deviations above the mean --  so due for a correction. Stock markets have crashed in the past when they became expensive. Greed and fear are powerful motivators. Given current inflation and geopolitical fears, we should not feel lucky going forward. Will (can?) AI continue to buoy up the stock market?

Conclusion

The past 18 years have been  the longest bull market ever!!  Stocks and bonds have gone up every year, except 2022. Stein’s Law says: “If something cannot go on forever, it will stop.” 40 million baby boomers will be in the Retirement Risk Zone for the remainder of this decade during which losses can ruin the rest of life. There’s a 40% chance that the typical TDF will lose money in at least one year remaining in this decade. That’s a bad gamble.

There are safer TDFs with about half the risk of losing money near retirement, but they are not popular, yet.