The Best Investment Strategy for IRAs
- IRAs are invested 60/40 in stocks/bonds regardless of age and individual needs.
- A better approach is to follow a target date fund glidepath even after retirement
- An even smarter choice is to select a personalized target date portfolio
There are three main types of retirement savings accounts: (1) Individual Retirement Accounts (IRAs), (2) Defined Contribution Retirement Plans (401(k)s, 403(b)s, etc.) and (3) Defined Benefit Pension Plans. In total there’s about $30 trillion in US retirement savings plans spread roughly equally across the three types.
Beneficiary choice is a major differentiator across these plans. In defined benefit pension plans beneficiaries have no investment choices; all of the investment risk is absorbed by the plan’s sponsor who guarantees a promised benefit. In defined contribution plans, beneficiaries choose investments from a fixed menu selected by the plan’s trustees; all of the investment risk is borne by the beneficiaries, but their choices are limited. IRA beneficiaries — both Roth and traditional IRAs — also bear all the risk but their investment choices are very broad; they are not limited to prescribed selections as are 401(k) beneficiaries. It is in fact this broad latitude that makes IRA investing a challenge.
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When you can go anywhere, where do you go? You can and should be much smarter than most IRA investors by focusing on the basics. That’s our recommendation in this article.
Asset allocation is the most important investment decision
Einstein said “Everything should be as simple as possible, but no simpler.” In investing, the simple truth is that asset allocation explains 100% of investment performance, despite the fact that a lot of time, energy and money are spent on choosing individual securities. Asset allocation is the composition of your portfolio broken out by asset class, namely stocks, bonds. real estate, etc.
The problem is that the normal IRA asset allocation is too simple, and follows an obsolete rule developed by financial consultants a long time ago: 60/40 stocks and bonds is the typical asset allocation for IRAs. This one-size fits all “solution” ignores age and investor risk capacity. A smarter choice was introduced into the institutional investment world about a decade ago. Target date funds (TDFs) are the darlings of 401(k) plans, having grown from nothing in 2006 to more than $2.5 trillion today, which is about 30% of all defined contribution plan assets and growing.
Target date funds follow a “glidepath” that starts out aggressively for young beneficiaries and tapers that risk as beneficiaries age.
Borrowing a page from the target date fund playbook
There are many good reasons that older investors should invest more conservatively than younger, giving rise to the 100-minus-your-age rule. But the fact is that older IRA investors are invested about the same as younger IRA investors, with about 55% in equities while younger investors are 60% in equities on average.
The most compelling reason for safety occurs as investors near retirement. Losses sustained in the 5-10 years before and after retirement can devastate lifestyles even if markets subsequently recover . That’s why this time period is called the Risk Zone. The notion of a TDF recognizes this fact, but most TDFs do not provide sufficient protection in the Risk Zone, except the patented alternative shown in the following graph.
Source: Employee Benefit Research Institute and Target Date Solutions
One step further
IRA investors can choose an off-the-shelf target date fund that will look like the typical TDF in the graph above. This trades off a one one-size-fits-all decision, namely 60/40, for another one-size-fits-all, albeit better choice. But the good news is that IRA investors can and should build their own TDFs that we call target date portfolios. The key is the glidepath.
Risk capacity that limits risk in the Risk Zone can be combined with risk preference by giving the IRA investor an option to move between glidepaths based on individual circumstances and needs. The following picture exemplifies this approach.
Note for example that an aggressive (Growth) investor would invest only about 45% in equities in the Risk Zone, less than the old 60/40 rule. Guardrails guide the IRA investor through time.
IRA investors enjoy the luxury of choice. Their investment options are limitless, making choices overwhelmingly complex. It appears that IRA investors on average have opted to overcompensate by making the choice too simple: 60/40 stocks/bonds is not a smart choice for most investors. The smart decision is target date portfolios tailored to individual needs and circumstances but with guardrails to control risk especially during the transition from working life to retirement.