Index funds have become one of the most popular investment choices for retirees, offering diversification, low fees, and steady long-term growth.

However, in recent times some financial experts have raised concerns that index funds could pose hidden risks, potentially turning them into a "retirement time bomb."

And when I say experts, I’m not kidding – ever heard of the movie The Big Short? It was based on real life events during the GFC and depicts the story of Michael Burry (played by Christian Bale) - a hedge fund manager who discovers that the U.S. housing market is built on high-risk subprime mortgages. He invests heavily in credit default swaps (CDS), essentially betting that the market will crash, and he won big.

So, when Michael Burry came out and said that index funds reduce the market’s ability for adequate ‘price discovery’ of asset values, and warned that it could lead to “ugly” outcomes, well you should probably listen.

But is there any truth to this claim, or are index funds still a safe bet for retirement?

The Popularity of Index Funds for Retirees

Index funds track a specific market index, such as the S&P 500 or ASX 200, offering exposure to a wide range of stocks without the need for active management. Their appeal for retirees includes:

• Low Fees: Since index funds passively track the market rather than requiring active management, they typically have low fees.
• Diversification: Investing in an index fund spreads risk across hundreds or thousands of companies, reducing the impact of any single stock’s poor performance.
• Historical Performance: Over time, index funds have consistently outperformed most actively managed funds, making them a reliable choice for long-term investors.

Given these advantages, it’s no surprise that retirees often allocate a significant portion of their portfolios to index funds. But could there be hidden dangers lurking beneath the surface?

Potential Risks of Index Funds for Retirees

While index funds are generally considered a safe and effective investment vehicle, there are some risks that retirees should be aware of:

1. Market Dependence

Index funds rise and fall with the overall market. Unlike actively managed funds, they do not attempt to protect against downturns. If the market crashes, so does the value of an index fund investment, which can be particularly risky for retirees who are drawing down their savings.

2. Sequence of Returns Risk

For retirees withdrawing money from their portfolio, the order of market returns matter. For example, if a major downturn occurs early in retirement, retirees may be forced to sell assets at lower prices, reducing their future earning potential and increasing the risk of outliving their savings.

3. Lack of Downside Protection

As a retirement specialist, this is something I think about quite often. Downside protection is obviously important for a number of reasons, but I think that one of the main reason is how major downturns affect the psychology of retirees.

Remember, if you are close to or already retired, your wealth needs to last as long as you do, and there is no fall back plan if things go wrong. Therefore, when the market crashes and all you can do is watch as you receive whatever negative return is given to you - this is exactly what’ll happen if you are heavily weighted to index funds. As you can imagine, this is unsettling and often results in poor decision making.

Alternatively, active fund managers can adjust portfolios to reduce losses during market downturns, whereas index funds simply follow the market.

A recent example of this is what happened to Index Bond funds between 2020 and 2024 - they significantly under-performed that of their active manager counterparts. This was due to rising interest rates, which active managers took advantage of.

4. Over concentration in Large Companies

Many index funds are weighted by market capitalization, meaning they allocate more money to large, well-established companies. If these companies become overvalued or experience major declines, index fund investors could suffer substantial losses.

Take the ‘Magnificent 7’ as an example. These companies include Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOGL), Meta Platforms (META), Nvidia (NVDA) and Tesla (TSLA).

If you were to invest in the S&P 500 index fund, then you are exposing yourself heavily to these 7 companies. In fact, as at the end of 2024 they made up about 35% of the index. That’s right, out of 500 stocks, they made up over a third of the market capitalization.

In the last year this index returned over 15%, however because the Australian Dollar declined over this time, the return to an Australian investor was closer to 26%. But here’s the rub – the Magnificent 7 made up over half of those returns. Therefore, you need to ask whether they can continue at this rate over the long term?

As a student of finance, I can tell you that the answer to this question is no. Why am I so confident in this opinion? Because no company can grow at a rate which is greater than the growth of the overall economy forever. Think about it – if they grew faster than the economy over the long term, then they’d eventually be the world’s economy!

5. Potential for Lower Future Returns

As more investors pour money into index funds, some experts worry that markets could become inefficient, leading to lower overall returns. This is effectively the concern that Michael Burry has. I don’t know if he’s right or wrong but what I do know is that if he is right, then those who are late to understand this concept might just get ran over.

So, while this is a debated topic, retirees relying on index funds should be aware of this.

Some might call this scare mongering, but you could also argue the same about what happened just prior to the GFC when there were voices out there expressing major concern about certain elements of the financial markets – as mentioned earlier, this is literally what The Big Short is about.

Conclusion

Are index funds a retirement time bomb?

Not necessarily - but they do come with risks that retirees should understand and manage carefully. Simply throwing your hands in the air and saying “this is beyond me” will not serve you well.

While index funds offer strong long-term performance, low fees, and diversification, their vulnerability to market downturns and sequence of returns risk means that a one-size-fits-all approach is not ideal, particularly for retirees.

The key is to structure your portfolio properly to begin with and this starts with understanding your tolerance for risk, your life stage and what is required to protect you during any market downturn so that you don’t blow up your retirement plans.