Behavioral Finance: The Key to Your Financial Independence

When it comes to choosing your 401(k) lineup, it’s easy to become overwhelmed by your options. It’s likely why more than 70% of 401(k) plans include at least one target-date fund. Also known as lifecycle or age-based funds, target date funds were created to simplify the investment choices for 401(k) plan contributors. Depending on your company’s 401(k) plan, they may be named something like Target Date Fund 2050, meaning you anticipate retiring around 2050. Target-date funds give employees the option of choosing one fund that diversifies their investments among stocks, bonds, and cash (the allocation) throughout their working life.

Considered a “set-it-and-forget-it” investment option, some investors choose target date funds as a default so they can avoid having to rebalance and update their portfolio allocations over time. The theory is that younger participants, having more years until retirement, can take higher risks in order to achieve higher expected returns. Since the funds focus on a selected time frame or target date (usually retirement), its asset allocation mix becomes more conservative as that date approaches. The percentage of stocks is reduced, and the percentage of bonds and cash is increased.

While target date funds may help encourage employees to participate in their company’s 401(k), there are a few misconceptions about how they work, and it’s important to understand these considerations before choosing your 401(k)’s investment lineup.

Target Date Funds Can Significantly Vary

Many investors get caught up in the year attached to a target date fund. If they change jobs and contribute to a different 401(k) plan, they may assume the target date fund is the same as their previous plan. Or, they believe that a 2050 target date fund is nearly identical to a 2055 target date fund.

However, target date funds with the same target date can significantly vary in their portfolio lineup. Fund families typically have their own unique approach with their target date funds, meaning a John Hancock target date fund likely won’t offer the same ratio of stocks and bonds as a Fidelity plan.

Take a look at this example from InvestorJunkie:

The percent of equities at age 65 significantly differs between target date families. When each of the target date funds has its own fee structure, mix of assets, and risk tolerance, it’s nearly impossible to measure performance between these funds.

Target date funds don’t just vary by their lineup. They can also have different fees.

As we can see in the chart above, the expense ratios considerably vary based on the target date and the target date family. Fidelity Freedom is more than 0.5% higher than Vanguard, which can take a toll on your portfolio when you’re investing for several decades.

Should I Invest in a Target Date Fund?

Like Though not a panacea, target date funds offer a reasonable alternative to the often confusing world of too many investment choices. Ultimately, there isn’t a single recommendation one can make for everyone. Each person has unique needs and circumstances, and they need to be taken into consideration when selecting their 401(k) lineup.

Before choosing a target date fund, there are a few factors to consider.

What do you want the fund to do for you?

Do you want a fund that is at its most conservative allocation when you retire or a fund that will take you through retirement? A target date fund’s allocation changes based on a set timeframe. If your fund is designed to help you get TO retirement, the amount invested in stocks will substantially decrease as you near your retirement date.

A fund that’s designed to get you THROUGH retirement changes allocations based on your life expectancy. These funds will have a greater amount in stocks at retirement than the to funds and thus be higher risk. Knowing which type of fund you own is critical to your ability to assessing its riskiness, along with its long-term expected returns if you are able to stay the course with it through troubled times.

What are the funds’ target allocations?

Whether it’s a to or a through plan, what are its target allocations? How are decisions about allocation made and do those choices complement your needs?

What's your risk tolerance?

Target-date funds can be more aggressive or more conservative than expected. During the 2008 financial crisis, many investors with 2010 target-date funds suffered severe losses because they didn’t realize their portfolio was invested in more stocks than they thought. Would you have stayed invested if the fund had struggled in 2008? If not, perhaps you should look at a more conservative option.

What are the fees?

Target-date funds can often cost more than other funds because they’re known for their long horizons, and their fees will vary by target date family and target date. If you are more cost conscious, you may prefer to invest in index funds.

Choosing Your 401(K) Lineup.

When there are a plethora of investment options from which to choose, take the time to understand what you want from them and find a fund that meets your needs. If you would like to discuss target date funds or other 401(k) options. I encourage you to reach out to me. Call my office at (949) 221-8105 x 2128, or email me at michael.loo@lpl.com.

The target date is the approximate date when investors plan to start withdrawing their money.

The principal value of a target fund is not guaranteed at any time, including at the target date.

No strategy assures success or protects against loss

Like many in my generation, I prefer to subconsciously minimize the odds that I’ll become ill and ignore the reality that I’ll eventually pass. Unfortunately, the harsh reality is that illness and death are inevitable. Enter another subject we tend to ignore: Life Insurance. For many Americans – particularly young and/or single adults, life insurance is nothing more than a plot point in a Hollywood movie or true crime drama: the money collected by remaining relatives after someone has passed. However, life insurance, like health insurance, is just something you need to have. It can provide financial security for your loved ones, cover end of life expenses, and can even provide tax free income.

There are two different types of life insurance: temporary and permanent. The most common form of temporary insurance is Term insurance. Term typically lasts for a specified “term” of years, hence its name. Permanent – on the other hand – stays with you for your entire life, provided you continue to pay the premium, or have developed an account value large enough you no longer have to pay in. There are a wide variety of insurance policies available under the permanent life insurance umbrella, such as: whole life, universal life, variable universal life, and indexed universal life.

To put in another way, Term insurance can be thought of as renting insurance. You pay a monthly premium for the coverage but once the specified term of time is up that coverage goes away. The term can vary from 5 years up to 30 years. With some companies you can continue the policy, but you will have to pay premiums that are a multiple of what you had been paying during the “term” of the contract. It is used to provide protection for liabilities that will disappear after a certain time period ex: raising children, your mortgage, or income replacement. In your 20s-50s you have more people depending on you; therefore, if something were to happen to you (e.g. illness, death) you need an insurance policy that will take care of the people you support. If you pass away, you need enough coverage to pay off any existing debt, provide income replacement, and cover any other miscellaneous expenses associated with supporting your family. This coverage makes a difficult time a little bit easier by reducing the financial burden and allowing loved ones time to grieve without worrying about impending bills. Term insurance is perfect for this type of coverage as it has the lowest premiums and can be structured to disappear once certain liabilities disappear (e.g. mortgage is paid off, kids are out of the house, and your income is no longer critical to the security of your family).

Permanent Insurance, on the other hand, can be framed as owning the insurance coverage. As with term insurance, you pay a monthly premium; however, the coverage stays with you for the rest of your life, not just a specified term of time. Once your family is out of the house and your liabilities are decreased you still want to maintain some level of insurance coverage to cover end of life expenses and provide for loved ones. Permanent insurance is a great choice to cover these remaining liabilities. The premiums for permanent insurance are higher than those for term insurance because, unlike term – where the insurance company may not ever have to pay out the policy- permanent insurance means a guaranteed payout – assuming you’ve paid the premium. At some point the insurance company will have to pay. Additionally, part of these monthly premiums are placed into a cash value account which, depending on the type of policy, earns a fixed or variable rate of return and can provide tax free income. This income can be used to fund an early retirement as it can be accessed prior to age 59 ½ – the age required to legally withdraw from retirement plans without incurring penalties.

But what if you want to access the death benefit in an insurance policy without having to die – sound too good to be true? In fact, some insurance policies allow you to access death benefits before actual death! These policies feature Accelerated Benefit Riders (ABRs) which allow you to accelerate (or, in other words, use) the death benefit while still alive to cover certain terminal, chronic, or critical illnesses. Unlike health insurance, which only reimburses medical expenses, ABRs provide tax free money for you to use as you wish, assuming you have an ABR event. You can use this money for experimental treatments that health insurance will not cover or use it to travel the world. There are no restrictions on how the money is spent.

Now you know about life insurance and the many different options and benefits available to you – consider working with a financial planner to discuss the right life insurance policy for your needs.

If you have questions about insurance or any other aspect of your financial life please do not hesitate to reach out to me at zach.swaffer@trilogyfs.com

This article contains only general descriptions and is not a solicitation to sell any insurance product or security, nor is it intended as any financial or tax advice. For information about specific insurance needs or situations, contact your insurance agent. This article is intended to assist in educating you about insurance generally and not to provide personal service. Guarantees are based on the claims paying ability of the issuing company.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.