SMI executive editor Mark Biller joined MoneyWise Live hosts Rob West and Steve Moore yesterday to explain the basics of "target-date funds," which are available via many workplace-based retirement plans.

Although such funds may seem to be a "one-size-fits-all" option, that is not really the case.

To listen, click the play button below — or, if you prefer, scroll down for a transcript. (For more radio appearances by members of the SMI team, visit our Resources page.)

MoneyWise Live airs daily at 4:00 p.m. ET/3:00 CT.

To ask a question on a future program, call 1-800-525-7000 and mention you have a question for either Mark Biller or Matt Bell of Sound Mind Investing.


Transcript

Steve Moore: Rob, terms like "asset allocation" makes some people's eyes glaze over. So let's just think of it as "not putting all your eggs in one basket."

But no matter what you call it, obviously Mark Biller, executive editor at Sound Mind Investing, he has a way of making it simple to understand — and we always consider him as a "good egg."

Rob West:  Alrighty. What an introduction. Hi. Mark. Welcome back to MoneyWise Live.

Mark Biller:  I think I got off easy today, Rob.

Rob West:  Somehow, I think so my friend. All right, to the topic at hand. Asset allocation is about diversification and, Mark, with these so-called target date funds, we're adding a time element to the equation, so I'd love for you to explain that for us.

Mark Biller:  Well, sure. As a general rule, a person's investment portfolio really should be weighted toward the stocks side when they're young and then move more toward bonds as they get older. And the reason for that is stocks have historically provided the best returns of all the asset classes, but stocks also come with higher risk. So when you're young and you've got lots of time to recover from any stock market losses, it makes sense to have the bulk of your portfolio in that higher returning asset class.

But as we get older and we've got less time to recover from big market setbacks, then it makes sense to gradually shift to a more conservative portfolio. And that generally means going from stocks to bonds with some of your money — doing that just simply decreases the risk as you get older.

Now, all of that sounds pretty simple, but for an individual trying to figure it out on their own, it can be kind of tricky. When exactly should a person start cutting back on stocks? What kind of bonds exactly should they buy at that point?

And so in the 1990s, mutual-fund companies rolled out a new type of fund designed to free investors from wrestling with those types of questions. And these are the target-date funds or "lifecycle" funds that we're talking about today. Now, these funds got a big boost about a decade ago when Congress passed some legislation that did two things. First, it encouraged employers to automatically enroll their workers in 401(k)s and other retirement plans. And the second thing was it allowed employers to set a target-date fund as the default investment option in those plans.

Rob West:  Obviously, that was a huge help for people who just want to "set it and forget it." And as a result of that, we've seen a significant run up in the number of assets in this type of investment.

Mark Biller:  Absolutely. Before, employees had to kind of pick their way through the list of investment choices, and now they have this simple alternative of an all-in-one solution that automates this process of moving from stocks to bonds as they get older. Plus, like we mentioned, they're automatically enrolled in that if they don't choose something different. So the easy thing with target-date funds is you just have to pick your target date, which is typically a year that's close to your planned retirement date. For example, if you're planning to retire in, say, 2034, you'd look for the 2035 retirement date fund and just pick that one.

Vanguard says that, as opposed to a decade ago when about 18% of their retirement plan participants were using these funds, today it's more like 77%. So as you were saying, Rob, just a huge increase in the assets and the number of people using these funds.

Rob West:  I'd love for you to get a little more granular. Let's open the hood here and give us a sense of what's going on inside these funds.

Mark Biller:  Sure. The holdings in a target-date fund are going to be a collection of underlying funds from whichever fund company is offering the product. In other words, you're going to have an underlying stock fund or two, an underlying bond fund or two, some kind of a cash holding — and you may have some other small extras like a commodity fund or something like that, depending on which company is offering the product. The interesting thing here, Rob, is because each fund company has its own unique perspective regarding what an appropriate asset allocation is, these target-date funds — even the ones that are based on the same retirement date — can vary quite a bit in their portfolio mix.

I'll give you an example. If you look at the 2035 funds, the Fidelity 2035 fund has about 86% of its assets in stocks. Now, if you look at the Vanguard 2035 fund, it has about 76% of its asset in stocks. So they're both 2035 funds targeting the same retirement they, but they've got about a 10% difference in how much stock they hold.

Rob West:  Mark, I want to go further on that, but before we do, there's one thing that comes up often is people ask, "Well, I might be retiring on this date, but if the Lord tarries and I have good health, I could need this money for 20 or 30 years in retirement." What kind of allocation do we see continuing in appreciating stocks even at retirement — when you get to, let's say, 2035?

Mark Biller:  Yeah, that is such a good question, and it really brings up this issue that we saw a lot in 2008 in the big downturn that we had — the last big bear market. And really what we're dealing with there is you have two different philosophies with these target date funds. There's one group that's kind of managing to that retirement date and saying, "Okay, we're going to take you to 2035, at which point our job is done and then you have to figure it out from there." Other funds take more of a through that retirement date. In other words, okay, you're retiring in 2035 but, as you mentioned Rob, "I'm still gonna have to invest for another few decades" — potentially at least a couple decades, probably.

And so what happened in 2008 was, uh, there were funds that had retirement dates of 2010 — so just a couple of years out. And some of these funds did about as you'd expect, with relatively moderate losses. But there were others that had really substantial losses cause some of these still had more than 50% of the assets in stocks. So huge performance differences across these funds. And as a result of that, most target-date funds have become significantly more conservative as that target-date approaches. But there is still some variation. So you really do want to take a look and see just what your fund owns now and what that "glide path" looks like to that retirement date.

Rob West:  As you said, they're presented as one-size-fits-all and yet they vary somewhat significantly from fund family to fund family. So how do we pick the right one for us?

Mark Biller:  Let's not lose track of the big picture. For most people who really don't know what they're doing when they're choosing funds in their 401(k), they're probably only going to have one set of target-date funds. So the only thing they really need to do is identify which year most closely corresponds to their anticipated retirement date. And for those folks, these target-date funds are probably going to be a pretty good choice. So I don't want any of this other detail that we're going into to obscure the fact that, for most folks, these are a good option.

Now where it gets a little bit trickier as for those who are a little more engaged and maybe more knowledgeable about their investments. Those folks are taking into account some other factors. They're looking at their portfolio-allocation decision, not only based on their projected retirement date, but also factoring in their risk tolerance, their savings level, their health, and so on. And since a target date fund can't really account for those variables because it's a one-size-fits-all blunt instrument, our take is that for those folks there may be a little bit better option if they're willing to keep up with the changes as they approach retirement because they can fine-tune their holdings a little better outside of target date fund.

But again, I want to reiterate, for most folks within a 401(k) or other retirement plan, if you're thinking, you know, this sounds like a pretty good idea to me, then it probably is a pretty good idea for you. It's probably a good option. The one thing you would want to do, that we would encourage you to do, is to look into the details of your specific fund to see what that stock/bond glide path looks like as you're moving towards retirement, just so that you can be sure that you're comfortable with the amount of stocks and the amount of bonds that they're going to have you in at each stage. So you'd want to just look at the fund information for your target-date fund, and if that seems appropriate and fine for you, then that's probably a good option for your 401(k) pick.

Steve Moore:  We have just a little bit of time before we have a hard break coming up here. What are the common mistakes people make when they have and are using this kind of fund?

Mark Biller:  Well, I think that, you know, really the main goal of these types of funds is to minimize the big mistakes. That's really not the issue. It's more the big mistakes happen when you're not utilizing a fund like this if you don't keep up with these decisions yourself.

Rob West:  Great information today, Mark. And by the way, these target-date funds don't replace getting godly counsel, some retirement-planning along the way — and if you want to get to some great help on this, visit our friends there at soundmindinvesting.org. Mark, thanks for being with us today.

Mark Biller:  Thanks, guys. 

Steve Moore: Thanks, Mark. You'll find his article on target-date funds online at soundmindinvesting.org. Your calls and questions next at (800) 525-7000. With Ron West, I'm Steve Moore. We'll be right back.