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What You Need to Know About Retirement Income Funds

Adam Zoll
Josh Charlson, CFA

Adam Zoll: For Morningstar, I'm Adam Zoll. Investors using target-date funds to save for retirement may wonder what happens once that target date is reached.

Here to answer this and other questions is Josh Charlson, a Morningstar senior fund analyst.

Josh, thanks for being here.

Josh Charlson: Thanks for having me.

Zoll: This year is 2014; next year is 2015. People who have a 2015 target-date fund may be saying, what happens next year? Do I get all my money back? What happens to the allocation of my fund? Can you explain what happens at the end, once a target date is reached with target-date funds?

Charlson: Probably what's going to happen right away is not much of anything. Typically what happens in a target-date fund, once you get to that target date--2015 if you are in a 2015 fund--usually they are going to let those assets sit there for a while. Depending on the philosophy, they might set an allocation there and then not change it at that point, or they might continue to evolve it to get it more conservative.

At some point they will roll it into the retirement income fund, if there's a retirement income fund associated with [that target-date series]. Not every series has one, most do. That would generally have to be approved by the board. So the 2015 fund would liquidate, and you end up in the retirement income fund at that point.

Zoll: Let's talk about the retirement income fund. What exactly is that and what does it invest in?

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Charlson: That's the terminal point usually of the glide path. It is a mix of stocks and bonds usually. Most target-date managers have a philosophy that you need some capital appreciation in retirement. So they are really balancing that need for capital appreciation with the need for protection of capital. The average allocation to stocks in a retirement income fund is about 30%.

Zoll: That's probably higher than a lot of people would realize.

Charlson: Yes. I think one misconception perhaps about retirement income funds is that you are getting a lot of income from them. In fact, that's not the case. The bond portfolios tend to be managed very conservatively. There is that capital allocation to equities, which is going to give you more capital appreciation than income. So, they are not necessarily the place to be if you are looking for a lot of yield.

Zoll: Within the fixed-income portion of the retirement income fund--are these all pretty much managed the same way? Are they all generally Treasury-heavy, or is there a little bit more variety there?

Charlson: There is some variety, just as there is at other points in the glide path. They do tend to be managed fairly conservatively. Duration tends to be shorter for one thing. But you are going to see a range. For instance, some will have some high-yield exposure still, generally not super aggressive; whereas, others are purely benchmarking the Barclays Index. Some have foreign bond exposure. Sometimes a fourth to a fifth of the portfolio could be in foreign bonds. Others have zero. So there are some differences there.

Zoll: Are there specific target-date series that are particularly well-suited to manage this more conservative retirement income portfolio?

Charlson: You will want to look at the glide path philosophy, both when you are investing in a target-date series and then down the road as you are approaching retirement. For instance, around that 30% average, there is a range of equity allocations from about 15% to 45%.

In a fixed-income portfolio, some will hold more cash. Some are holding a more diversified range of instruments. In general, the target-date series that Morningstar analysts like, that they give Medals to, are ones that we would generally favor the retirement income offering as well. You might want to look at how conservative they are relative to your risk tolerance. You may want to look at their bond-management capabilities.

So, firms that we like that have strong fixed-income shops, like Fidelity, PIMCO, T. Rowe Price--those are all options to look at.

Zoll: Does the allocation within the retirement income fund stay static throughout, or does that change over time?

Charlson: Usually once you're in the retirement income fund, that's a static allocation. While you are still in the 2015 fund, or whatever that dated fund is, you may see the allocation still changing. The income fund, that's the terminus. So you are going to see a static allocation at that point.

Zoll: An investor who wants to stay with the target-date retirement income fund, but maybe thinks that the stock allocation is too heavy, or maybe not heavy enough, could potentially add other holdings in addition to the target-date fund to change their own personal allocation?

Charlson: That's a point where you have to look at your spending needs, your income needs, and say, is this satisfying them or do I need to diversify? I think the fund companies tend to be conservative in their approach here. They don't know exactly what investors and participants are going to do. So, they are playing it safe, assuming that they may pull their money and do something else with it.

Zoll: The retirement income fund is certainly an important piece of the puzzle for target-date savers. Thanks for being with us today.

Charlson: Glad to help out.

Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.