Are Target Date Funds The Best Choice for Educators?

One of the most helpful innovations in both investing and retirement planning has been the Target Date Fund. If you’re not a familiar, a Target Date Fund is one investment that allows you to pick the date at which you anticipate needing your money (typically when you expect to retire), and the fund is setup to automatically allocate your investments appropriately. Over time, the fund itself adjusts those allocations to make sure they stay appropriate in relation to how many years you are from retirement. In general, that means when you are far away from retirement (typically when you are very young), they invest more in “riskier” assets (stocks) and less in “safer” assets (bonds). As you gradually get closer to retirement age (the “target” date), they gradually shift your allocation to be more equally weighted between stocks and bonds, and as you approach and enter retirement they shift to a much heavier allocation to bonds and a much lighter allocation to stocks.

These funds have been amazingly helpful for folks. They can choose one fund when they first start investing and never really make another investing decision along the way (other than hopefully increasing the amount they invest as they are able). No need to learn a lot about investing, just estimate when you will retire. No need to periodically rebalance between different funds, the fund does it for you. No need to worry whether you are doing the right thing, smart people have already figured it out for you. And, to top it off, many Target Date Funds (although not all) are composed of underlying stock and bond index funds, so they (often) have very low fees associated with them. Win-win-win-win.

So, why am I writing this post? Well, to be clear, I am not against Target Date Funds. I think they are great and, if you are in one, I’m not saying you’ve made a poor decision or that you should definitely change your investments. It is likely a good investment choice for you and you’ll be just fine if you leave all of your investment money there (again, assuming it is a low-cost, diversified index fund based Target Date fund). But the question I want to examine is whether it is the best investment choice for you and, particularly, for educators.

Most public school educators belong to a pension plan. The details of those pension plans vary dramatically, depending on what plan you are in, and often on when you began in the plan and when you vested in the plan. And folks in some plans pay into both the plan and Social Security, but in others they only pay into the plan (and do not pay into or get Social Security). In general, most of the pension plans that educators are in are either a defined benefit plan or a hybrid of a defined benefit and defined contribution plan. In short, a “defined benefit” plan means that you will get a predetermined, guaranteed benefit for life in retirement based on a formula that typically takes into account your age, your years of service credit, and your highest average salary. This is in contrast to a “defined contribution plan” (like a 401k/403b/457/IRA), where the benefit you ultimately receive is based on how much you invest, how your investments do, and how quickly you withdraw the money in retirement (in other words, it can end up producing less income than a defined benefit and can even run out).

For the purposes of this post, I will focus on Colorado PERA, which is the pension plan that public employees (including educators) in Colorado belong to. While the specifics of this example apply to Colorado, the basic idea will apply to educators in almost any defined benefit pension plan. Colorado PERA is a Social Security replacement plan, meaning Colorado educators only pay into PERA, but not into Social Security. Like most pension plans, PERA has made changes over the years so the exact benefit you are entitled to depends on when you were originally hired into the plan and when you vested. In many states these are called “tiers“, but in Colorado they are just referred to as Highest Average Salary Tables.

Unlike in many other plans, the benefit calculation across PERA’s different “tiers” is basically the same: it’s 2.5% times years of service times Highest Average Salary (HAS). The difference is that for folks that are more recently hired into the system, when they can retire with full benefits (or even reduced benefits) is later, their highest average salary may be figured on five years instead of three and, for very new hires, Section 125 contributions do not come out pre-PERA contributions (which doesn’t affect their ultimate benefit in retirement, but does mean they will contribute more into the system along the way). (If you want to learn more, just buy the book :-).

There are, of course, lots of different career paths and lots of different combinations of age, years of service and highest average salaries. But I’ll just use a reasonable, fairly representative example of the type of benefit that a Colorado teacher retiring today might receive (you can adjust this up or down however you’d like). So let’s take a 55 year old teacher who has 32 years of service credit and has an HAS of $90,000. (Salaries vary widely across districts, of course, but this is a reasonable amount for the Denver metro area.) This teacher would receive 80% of their HAS, so a yearly Option 1 benefit of $72,000. (If they were to choose an Option 2 or 3 benefit, it would be lower, perhaps by as much as 10%, but their co-beneficiary would continue to receive 50% or 100% of their benefit for their lifetime after the member’s death and, if they predecease their co-beneficiary, their benefit automatically pops back up to the Option 1 level.)

That means that they have a guaranteed monthly income of $6,000 for life, with a small cost-of-living increase each year beginning in year three. They may also have a spouse with a retirement income (pension or Social Security), and they may even have some Social Security of their own. (Even though Colorado PERA members don’t pay into Social Security, many of us have enough Social Security credits from previous employment to still get a small benefit, although it will likely be reduced by the Windfall Elimination Provision.) And since it’s not all that unusual for an educator to be married to an educator, many folks will have two PERA pensions of this size.

Why is this important? Because the pension that many educators will receive is often a significant amount (usually much more than a typical Social Security benefit, and often starts much earlier than Social Security), is guaranteed for life (the same as Social Security), has a small cost-of-living increase built in (as does Social Security, although its COLA is higher); therefore many educators will be able to live in retirement completely (or almost completely) off of their pension income. Educators who know (or at least expect) that this will be the case for them should think carefully about how this might affect their investment decisions throughout their career (and even into retirement).

Back to the example. With a yearly guaranteed income of $72,000, we can use the 4% “rule” (really more of a rule of thumb, but very useful for helping us think about this), to figure out that that’s the rough equivalent of having $1.8 million invested in fixed income (bonds). That’s because it would be reasonable to generally expect you could withdraw 4% of the $1.8 million each year ($72,000) without exhausting the principal during your retirement (the easy way to calculate this is to just take your expected pension(s) and multiply by 25). (And, for a two-PERA family in this example, that would be $144,000/year and the rough equivalent of $3.6 million in bonds.) Just as importantly, it also means that educators with a defined benefit face a much lower “sequence of returns” risk.

Briefly, folks who are getting most of their retirement income from their investments (401k/403/457/IRA/Taxable investment accounts) have to worry about sequence of returns risk; steep drawdowns in the first few years they are retired. They have to withdraw money from these accounts to live on because they don’t have a defined benefit to draw on and, if those withdrawals coincide with a significant decline in the markets, their “nest egg” can get so low that it will no longer support that level of withdrawal (and can even become exhausted – go to $0). Because of this risk, most folks in this situation choose to be in less risky investments (i.e., more bonds and less stocks) because bonds tend to be much less volatile than stocks so it’s very unlikely to suffer those steep drawdowns. The downside of that, however, is that it lowers their expected long-term return on investment.

But for educators in Colorado PERA (and similar plans), they don’t face that same risk (or at least not to the same extent). Because they likely can live completely off of their pension, or possibly just need a little bit from their savings and investments to supplement their pension, they are somewhat inoculated from sequence of returns risk. If they retire into a down market, they can simply choose not to withdraw any from their investments (or, at worst, just draw a little bit), until the market recovers, and therefore they won’t be subject to the same drawdown effect and the possibility of not being able to support their living expenses (or running completely out of money).

So, finally, I’ll get to the point of this post. (Sorry, but the background and rationale is important.) This means that for educators who expect a good defined benefit, and especially for two-educator families who expect two good defined benefits, they should consider an asset allocation that is much more heavily weighted toward stocks, perhaps even 100% stocks. Now, to be perfectly clear, this depends on the rest of your financial situation and, crucially, on your risk tolerance. While over time stocks are very likely to outperform bonds, and while over time stocks have always gone up, stocks are also much more volatile than bonds and can also go down – and often by a lot (for example, by over 30% in March of 2020 and by about 50% in 2007-2009). So not only do you need to take into account the rest of your financial situation when making this decision, you have to take into account your own likely behavior should the stock market drop precipitously. If you suspect (or know) that you would panic and sell your stocks when the market drops that much, then you don’t want your asset allocation to be so aggressive. By having more “safer” investments like bonds in your portfolio, you will be more likely (behaviorally) to “ride out” the drop in the market (with the trade off being lower total returns over time).

On the other hand, if you know that you can “ride out the lows”, perhaps because you’ve done it before (2007-2009, or March 2020) or because you know that the mathematics has always worked out in the long run, then you should consider making your asset allocation much more “aggressive” (heavily weighted towards equities). Since your long-term retirement investments are going to be invested for a long enough period of time that you should be able to ride out the lows, and because you have a defined benefit that you can count on, you should even consider making your retirement investment portfolio 100% equities. That’s not a typo, if you have a good defined benefit, you should consider making your long-term retirement investments 100% in stocks.

So this brings us to whether Target Date Funds are the best choice for educators expecting a decent defined benefit. I would suggest that for many, the answer is no, it is not the best choice (again, not a bad choice, but not the optimal one). Because Target Date Funds always allocate some of your money to safer investments like bonds, 10% even when you are in your 20’s to as much as 60% or more in retirement, your expected return over time will be lower than if you had more allocated to equities. Being me, I’ve created a spreadsheet to illustrate this. To be clear, like all projections this spreadsheet has to make some assumptions, including that each year’s return will be exactly the historical average, which is pretty much impossible. But it is still directionally accurate and illustrates the concept very well. You can also change any of the numbers in the cells outlined in purple: initial balance, monthly contribution, yearly percentage increase to your contribution, expected returns for stocks and bonds going forward. If you want, you could even go in and change the contributions yearly in the table instead of using the percentage increase, change the stock allocation to match your Target Date Funds if they are significantly different than Vanguard’s, and even add in withdrawal amounts once you retire and want to start pulling some of the money out.

I’ve used the historical returns of stocks and bonds since The Great Depression (source) and the latest allocations from Vanguard’s Target Date Funds (source).

The results? Well, pretty striking. After 30 years, the Target Date Fund – with the exact same amount invested – would have about $156,000 less than the 100% stock investment. Even if you “only” work for thirty years, you aren’t going to withdraw that entire amount on your first day of retirement, so let’s look a little further. After 40 years it would have about $868,000 less. After 50? $4.4 million less. That’s the power of compound interest combined with higher overall returns. (And before you say, “Yeah, right, 50 years,” for someone who starts teaching at age 23, 50 years of investing still only take them to age 73, meaning they are likely to still have 10-20 years of life expectancy left.)

So, again, the point of all this isn’t to knock Target Date Funds. I think they have been a great innovation and, if that’s where you’re invested, you’re in good shape. But so much of the financial information you read doesn’t ever speak to folks with pensions (because they are very rare in the private sector) and, consequently, often ignores this perspective on asset allocation.

Even if you are not comfortable going 100% equity, you might at least consider increasing your equity exposure by perhaps investing a certain percentage of your overall contribution each month into equities and the rest into a Target Date Fund (for example, 50% into a Total Market Index Fund and 50% into the appropriate Target Date fund). This will “tilt” you more toward equities, but with a bit less volatility due to the Target Date Fund component.

So are Target Date Funds a good choice for educator’s retirement accounts? Yes.

Are they the best choice? Probably not.