Show Transcript
On today's show as I mentioned we're going to discuss things you don't know about target-date retirement funds.
So let's get into the show.
What is a target-date retirement fund?
The first question obviously is what is a target-date retirement fund?
Well a target-date retirement fund is a mutual fund that is typically found in 401(k) plans and we'll get into that in a minute of why you typically find target-date retirement funds in 401(k) plans.
But to get into the mechanics of what a target-date retirement fund is, it is a mutual fund that invests in a broad diversified portfolio of stocks and bonds. The mutual fund itself does not usually invest in individual stocks or individual bonds.
The target-date fund typically goes out and purchases other mutual funds that are stock mutual funds and bond mutual funds, that are held under the umbrella of a target-date retirement fund.
And the funds themselves, the target-date retirement fund isa fund that's designed around the target-date of your retirement.
So when these funds first were established they were established with the idea in mind that everybody has a target-date in which they wish to retire.
What do those dates mean?
So, depending on the date or the year, if you will, that you wish to retire you would pick a target-date retirement fund with that date and some examples of that are typically what you would see is a mutual fund company that offers target-date retirement funds would have the name of the mutual fund company and then next in that name it would say target retirement for instance2060.
Or it would have the name of the mutual fund company and say target 2040 or target-date retirement 2025 and what those dates are is the date in which again that you're targeting your retirement.
So the portfolio then overtime is adjusted based on your target-date of retirement. So depending on how soon are how far away your target-date of retirement is that fund may be fairly aggressive invested in stocks versus bonds or as you're getting closer to retirement it could be more conservative with more bonds than stocks in the portfolio and we'll get into some detail regarding these concepts of how the funds actually work as we go through the show.
But I wanted to talk about exactly what is a target-date retirement fund and it's designed to be as I mentioned earlier a fund that's made up of other funds and it's designed to be simple.
And that's why we find these funds and a lot of 401(k)programs because they're the funds and the programs are trying to make it simple for employees to invest their money every time that they're paid, so as new deposits from payroll withholdings are deposited in your 401(k) program then one fund needs to be purchased that is a widely diversified fund covering many different stocks and bonds funds within that portfolio.
Broad market exposure with one fund.
So in a typical target-date retirement fund you may find exposures to US stocks, international stocks, emerging market stocks. You may find exposure to real estate.
On the bond side you may have exposure to government bonds, corporate bonds and other types of bonds in the portfolio, as well as sometimes the position of cash.
Same fund with a different name.
So let's talk a little bit about the naming of the funds, the target-date retirement funds. We already talked a little bit about the names having target retirement and then a date in them.
But sometimes these funds are also known as other things.
Target-date retirement funds are obviously called target-date retirement funds, but sometimes those are known as lifecycle funds or age-based funds.
All of these three types of fund names are really the same type of concept regarding target-date retirement funds and they're designed to be simple.
They're designed to be one fund. They're designed to be funds that change the asset allocation over time.
So don't be confused if you're out there and you're looking at a fund that may be a target-date retirement fund that doesn't really have the name "target-date retirement" in the name of it because they could be again, you know target-date retirement funds they could be named lifecycle funds or age-based funds.
I'm sure there's other names out there. But those are the three primary names that a target-date retirement fund goes by.
Two different investment philosophies.
So the other thing with target-date retirement funds is there's two main types of target-date retirement funds
The first is based on what we call passive investment vehicles, meaning index funds.
So a target-date retirement fund made by other mutual funds that are index funds and just for discussion purposes today and maybe will produce a podcast about this in the future get into the specifics, but an index fund is a fund that is generally low cost that is designed to capture the returns of an entire market or investment style or asset class in a portfolio.
There's no market timing that's involved. No one's trying to guess what the markets going to do.
No one's guessing what interest rates are doing. It's just simply a fund that mimics the returns of those areas that you're investing in and again, whether it's the market, a style or an asset class in the portfolio.
The second area and type of target-date retirement funds are an active form of investment management.
And on the active side those target-date retirement funds are invested typically the same way, they're are still invested in stocks and bonds and potentially cash, but the twist here is those funds, and the underlined mutual funds that they invest in are actively managed.
So those managers of those mutual funds that the target-date retirement funds purchase are out trying to do exactly the opposite of what I just mentioned with index funds. They're trying to time the market.
They're trying to time interest rates to determine when interest rates may go up or down. They're trying to decide what companies are the best companies to buy; which ones are going to outperform.
So when you look at a target-date retirement fund you have to first understand that you're looking at a target-date retirement fund, but then next dive into how is the fund itself being managed?
Is it purchasing index funds or is it purchasing actively managed mutual funds?
And those are important things to distinguish because typically with a target-date retirement fund even though they come in many shapes and sizes and forms, one key driver of cost of that fund is going to be how the investment style is, if it's a passively managed fund or if it's an actively managed target-date retirement fund.
Target-date retirement funds in 401(k) plans.
So as we get into the show here, we're going to you know, talk a little bit more about target-date retirement funds in 401(k) programs.
But before we get there, let's talk about a little bit of the idea of how target-date retirement funds are marketed outside of 401(k)programs, and some of this falls over into why they're in 401(k) programs.
But the the way that their marketed it is to be a simple vehicle that if you don't want to spend a lot of time managing your money, you can simply buy one fund and have broad diversification between stocks and bonds and do it in a very low cost.
So this all seems great right?
Simple investing can still be complex investing.
I mean at the end of the day we're buying target-date retirement funds, typically one fund or two funds depending on the dates of those funds and what you're trying to accomplish and it's simple and low-cost.
But here's one of the problems. It's not a set-it-and-forget-it type of investment vehicle, even though those vehicles are marketed that way.
What I mean by that is at the end of the day just because you pick a target-date retirement fund that let's just use an example if you pick the target-date retirement fund of where's the target-date retirement 2030in the name of the fund, that fund is then assuming that whoever's investing in that fund is going to have a retirement date in 2030.
So that fund as we talked about earlier may start out, moderate to aggressive. But then as you get closer to that 2030 retirement date, that fund then becomes more conservative.
So where the problem comes in you may not understand that those funds automatically adjust over time to get from your current state of amore of a moderate or aggressive portfolio to a conservative portfolio within the target-date retirement fund.
And if you're not aware of that or you're not paying attention to that as you continue to get closer to your retirement date, you may be in a position where you don't want to be as aggressive, excuse me, as you don't want to be as conservative as the fund is making itself as you get closer to that date.
You may need to continue to take a certain level of investment risk that is now not consistent with the way that the fund is adjusting automatically to become more conservative over time as you approach, let's say again this example of the 2030 retirement date.
Can two funds be better than one fund?
So what people end up doing to compensate for that a little bit is purchasing a couple of different target-date retirement funds. The first one may be much further out.
They may buy let's say target-date retirement fund of 2060.That would be fairly aggressive and then they buy one that is more in-line with the date that they're originally targeting for retirement.
So when those two funds are blended together from an asset allocation standpoint, they're closer to the amount of stocks overall and bonds overall that they're comfortable within the portfolio and that also is consistent with what the investment goal is of what your retirement date is and how much you need at retirement.
That's another way to approach it is to buy a couple or potentially even three target-date retirement funds.
But as you do that, you're understanding the simplicity now is beginning to go away from the idea of buying one fund and forgetting about it. So what is the best course of action if you don't want to end up buying two or three different target-date retirement funds.
Better yet, build your own investment portfolio.
Well, the best course of action at that point then is to develop your own portfolio using different mutual funds or exchange-traded funds also known as ETF's in the portfolio.
That is my preferred way of doing it simply because you have more control over it and you can still do it in a very simple way.
You just have more granular control over your investment risk in the portfolio and how that is designed. So let's get into a little bit about why these are used in 401(k)'s because I mentioned that I wanted to talk about that a little bit.
And it's used for some of the same reasons we talked about, which is a simplicity of buying into one fund.
You can look at that and decide that, yeah I want to retire in 2030. So I'll just put all my money into this fund and I'll be just fine.But as we already discussed, that may not be the case and you need to be aware of how the fund adjusts over time to become more conservative.
Like I talked about earlier. The funds are generally lower costs. So as these funds are added into retirement plans, 401(k) programs. Um, that's great for investors since more pressure over time has been put on plan sponsors, your employer to include low cost investment options.
And then the idea obviously of the set-it-and-forget-it once you select the fund as your default fund for all new Investments every time you're paid and invested in the 401(k) to go into that fund there's nothing else to think about, you don't even need to do what is called rebalance your portfolio.
If you want to learn a little bit more about rebalancing I suggest listening to episode one of the Seeking Wealth show. We get into more in-depth concepts regarding rebalancing. But it's really intended to be a set-it-and-forget-it strategy for 401(k) programs.
So those are really the pros of having those funds in the program. And kind of the negatives here we talked a little bit about some of those things with target-date retirement funds, but you know the big thing is obviously the adjustment between stocks and bonds is a big thing.
You may think that you're invested a certain way today, but then as time goes on you forget that the fund automatically adjusts on its own or you're not quite sure at any given point how much you have in stocks and bonds because that is all now dependent about how frequently the actual mutual fund companies report to shareholders is too how much is in stocks and how much is in bonds at any given point in time?
Comparing the performance of two target-date retirement funds is very difficult, if not impossible.
So it's also difficult to measure the performance of a target-date retirement fund, because it is a moving target between how much is invested in stocks and bonds within the fund at any given time because it automatically adjusts as you get closer to your retirement target-date.
So this makes measuring performance of the fund very difficult because you can't set a static benchmark or multiple benchmarks for that fund because those benchmarks then also would need to adjust over time.
Sticking with the concept of performance, it's also important to note that the performance of one target-date retirement fund is also often difficult to compare to the performance of another target-date retirement fund.
So for example, if you were looking at a target retirement date of 2030 again, you could be looking at a target retirement fund from one mutual fund company with that same target retirement date as another and have completely different performance because there's no set rules and how target-date retirement funds have to automatically adjust.
So one mutual fund company may be more aggressive in its adjustments, becoming more conservative sooner, then later, as opposed to the other mutual fund company, even though both funds are called a target-date retirement fund of let's say 2030 using our example.
You have less control with target-date retirement funds.
One of the other things that is a negative for target-date retirement funds in that you need to be aware of is if you haven't saved enough for retirement you do want more control over how much you have in stocks and bonds.
Like we talked about earlier, you may need to take more investment risk than what will be allowed within a target-date retirement fund just because of the automatic adjustment that kind of what they call the glide-path of a target-date retirement fund.
So like I said, if you haven't saved enough or you're not sure if you've saved it enough, you do want that more granular control over how much you have in stocks and bonds.
So you may be sitting here wondering, you know, okay, so ifI don't use a target-date retirement fund, what do you supposed to do and how are you supposed to invest your money if you want to keep things simple?
At the same time have the proper diversification and proper amounts invested in stocks and bonds known as your asset allocation. So what you would do is typically buy simple total stock market index funds.
So most 401(k) programs offer some form of index funds, typically at least Standard & Poor's, an S&P 500 index fund.
Most though offer today total stock market funds and total stock market funds are the best way to design a portfolio if you're not going to use the target-date retirement fund and sometimes or even the preferred way of investing in the market.
And you can do that with sometimes buying two or three or four, depending on the complexity that you want to make the portfolio. But certainly you can get by with three total stock market type of instruments.
You'd buy one US total stock market fund, one international total stock market mutual fund and one total bond market mutual fund. So within those three types of funds you would own a globally diversified portfolio of stocks and bonds.
Now the advantage of designing and managing a portfolio using the three fund approach as opposed to the target-date retirement fund, an all-in-one fund set-it-and-forget-it strategy is that concept of taking the amount of risk that you want in the portfolio.
How much do you want in stocks and bonds and you can adjust those levers based on how much you put in each of the total stock market funds and bond market fund.
There is no such thing as a "set-it-and-forget-it"investment strategy.
So something to be aware of if you take the approach of designing your own portfolio so you have that static allocation to stocks, bonds and cash is the idea that's also not a set-it-and-forget-it strategy.
So as we talked about with target-date retirement funds you have to go back and you have to make sure that the allocation is right overtime and it's not becoming too conservative as you get closer to retirement.
The opposite kind of happens with designing your own portfolio using individual mutual funds in the example I just explained, except the opposite is that over time as you get closer to retirement you need to make sure that now the portfolio is not too aggressive as opposed to conservative with the target-date retirement fund approach.
What do I mean by this?
Well what I mean is that you're setting a static asset allocation and just as an example, if you had 50% in stocks and 50% in bonds, you would be putting 50% of your money into a total US stock market fund and a total International stock market fund and then the other 50% in the bonds and then rebalancing that over time so it remains at 50/50.
Typically once a year rebalancing if it's not a retirement account where automatic deposits that are being made regularly would then rebalance the portfolio for the most part to keep it in balance because you're always buying the same balance as you put new money in.
But when you're buying three different mutual funds and not using a target-date retirement fund, you have to make sure that as you get closer to retirement that a 50/50 in my example, 50% stock and 50% bond portfolio is still the correct asset allocation.
So now you're responsible for adjusting how much you have in stocks and bonds over time to make sure you're not too aggressive.
Where again in the target-date retirement fund, the fund itself will adjust on a glide path towards your retirement date and then become more conservative over time.
So at the end of the day, there's never really a set-it-and-forget-it investment philosophy, whether it's using one fund; a target-date retirement fund or it's using a couple different mutual funds in designing your portfolio.
So I wanted to cover target-date retirement funds on today's show and and at least talk about some of the major downfalls of those funds, even though I think that they were designed and put out in the marketplace with great intentions.
Target-date retirement funds are just not flexible enough.
Over time they are just funds that don't have a lot of flexibility and at the end of the day should be looked at as a fund that if you can avoid it because there's other good options for you in the marketplace again, whether that's in your 401(k) plan or you have the ability to buy other low-cost index based funds that I talked about earlier, a total US stock market fund or a total International stock market fund and a total bond market fund that generally is the preferred route because you can keep your costs very low you have control over it and it doesn't require much work to rebalance a two or three fund portfolio over time and it doesn't need to be rebalanced all the time.
Once or twice a year is more than plenty especially in a401(k) that's rebalancing itself to some degree every time you make a new deposit. So hopefully you learned something on today show about target-retirement funds.
By no means, was the show designed to cover all of the pros and cons of using target-date retirement funds, but we did want to cover some of the basic things that we hear about all the time and that, you know individuals such as yourself may be confused about and hopefully you listen to future shows and I encourage you to go back and listen to a couple of our earlier episodes.
If you have any ideas for future shows you could always drop an email to hello@firstmetric.com with any of your show ideas.
We'd be happy to evaluate them and determine if we think that they would be beneficial to all our listeners.
So again, thanks for listening today.
