The "Most Confusing" 401k Term
You know how I detest how confusing the financial services industry is. I get it. Unfortunately, this industry does its best to make even the simplest concepts more confusing.I came across an article recently that identified the “most confusing” term when it came to 401k plans. It seemed appropriate to break it down here.
First, the term itself is referred to as “glide path.” Before I get into breaking it down, this term was identified by a survey of 800 participants in 401k plans. The respondents were of various ages, plans and income levels. Only 4% of the participants knew what glide path meant.
To fully understand a glide path we must first talk about the term “Target-Date Funds.”Target-date funds have been around for years and caused quite a bit of trouble with the Great Recession a decade ago (I’ll explain in a moment). Target-date funds are connected to a future date that is supposed to connect with your retirement, often assumed to be when you turn 65. These funds are usually easy to identify in your 401k menu because they have numbers at the end of them such as 2020, 2035, 2050, 2065, etc.
Within these target-date funds you have an investment mix of equities (stocks) and fixed income (bonds).As you get closer to the date on the target-date fund the investment mix automatically changes to become more conservative. The process of the investments changing to become more conservative is what is referred to as the “glide path.” I assume it is supposed to refer to a gentle change in the investment mix so you have a soft landing when it comes to retirement.
A good, and easier to understand, example of how a glide path works is if you have a 529 plan for your kid. I feel it is easier to understand as the time frame is much shorter at 22 years (birth to completion of college) as compared to possibly 70 years on a 401k target-date fund (start working at 22, retire 45ish years later in your late 60s but maybe living into your 90s). Most people open a 529 plan with an age-based plan. This option automatically becomes more conservative as the child gets closer to age 18 when they will need the funds. This shift from maybe 100% in stocks when they are 3 years old to 100% short-term bonds at age 19 is the 529 version of a glide path.
Now, where target-date funds can and have caused trouble is the actual glide path. There were lots of issues with the actual investment mix a decade ago when the Great Recession hit. Many people mistakenly assumed a target-date fund marked at 2005, 2010, or even 2000 meant it would have been super conservative, maybe even 100% cash.Unfortunately, just because various target-date funds have the same year ending does not mean the underlying investments are treated the same. Some 2005 funds were 100% bonds and cash and others were along the lines of 40% stocks and 60% bonds and cash. The more conservative target-date funds had shorter glide paths, but the others did not.It came down to the latter types of funds assuming you would live well past age 65 and would still need to be invested in stocks, but maybe not as aggressively as when you were in your 40s.This was a nasty surprise for many people at a terrible time.
So, a glide path is simply how your target-date fund automatically adjusts the investment mix over time within your 401k. They are designed to become more conservative the closer you get to retirement.However, and I cannot stress this enough, be sure to take a look at the actual investment mix when you reach the date of the target-date fund. This may help save you from a nasty surprise of your own.