3 Target-Date Series for an IRA

Susan Dziubinski: Hi. I'm Susan Dziubinski with Morningstar. Investors have until April 15 to make an IRA contribution if they want it to count toward tax-year 2020. Should you consider a target-date fund for your IRA? Perhaps you should. Joining me today to talk about how target-date funds can work within IRAs and to share a few of his favorite target-date series is Jason Kephart. Jason is a strategist in Morningstar's multi-asset manager research team.

Hi, Jason. Thanks for being here today.

Jason Kephart: Thanks for having me, Susan.

Dziubinski: So, let's start out with some of the basics. Let's talk a little bit about what target-date funds are and how they work.

Kephart: Sure. Target-date funds are designed to be a hands-off total portfolio solution for retirement savers. Most target-date funds start off owning mostly all stocks and then gradually become more conservative by adding bonds as the target-retirement date approaches.

Dziubinski: Why are target-date funds something that people should be thinking about for their IRAs? Are there particular types of people who should be considering them?

Kephart: Use of the target-date fund is kind of like putting your retirement savings on autopilot. It's for investors that don't have a lot of time to spend on investing. The target-date portfolio manager takes care of everything from setting the asset allocation to selecting and monitoring the underlying funds, and also rebalancing is necessary to make sure that the risks don't get out of control.

Dziubinski: Now, Morningstar rates target-date series and target-date funds, and you're very involved in that process. If people want to evaluate a target-date fund or series for their IRA, what are some of the things you think they should be looking at?

Kephart: Anytime you're weighing your investment options, the first thing you have to consider is the fee. The good news is target-date fund fees are pretty reasonable considering they're designed to be your entire portfolio. The biggest driver of the fees is what kind of underlying funds they use. The ones that use all index funds tend to be the cheapest. The ones that use all active funds tend to be more expensive. And the ones that use a mix of index and active funds tend to kind of fall in the middle.

The other thing to consider is how much stock does it own at the target-retirement date. This is arguably when your nest egg's at the most vulnerable. And because you're not going to have any more contributions coming in, you also don't have any more time to make up for losses. So, the average target-date fund owns about 40% in equities at retirement. But that can range anywhere from 55% to less than 20%. So, making sure that that level of risk is something you're going to be comfortable with at your retirement date is definitely a key consideration to keep in mind.

Dziubinski: Jason, let's talk a little bit. Let's name some names and get into some of your favorite target-dates funds for an IRA wrapper specifically. Let's start out first with an all-index option.

Kephart: Cheap and simple is a hard combo to beat when it comes to investing. Fidelity Freedom Index totally achieves this. It's one of the cheapest options you can get with a low minimum investment. And it achieves very broad diversification using only a few index funds. One of the things we particularly like about this index-based series is that it uses a long duration Treasury index within its fixed-income portfolio. Most index-based peers just stick to the Barclays Agg, which is a good fund, but the long duration Treasuries tend to be a really good balance in times of equity market stress. So, we like that you get a little bit more extra defensive cushion in this bond portfolio.

Dziubinski: Let's go to sort of the other side of things and look at an all-active fund choice.

Kephart: It's no secret that we're big fans of American Funds equity funds at Morningstar. Most of them earn very high medalist ratings, and they have done really well for investors over time. Something that's kind of underlooked, I think, in their target-date series is just how well their bond funds work in combination with their equity funds. Their bond funds tend to act like bond funds when you need them to act like bond funds. And by that I mean in times like March 2020, when equities are falling out of the sky, their bond funds do a really good job of protecting capital.

Some peers tend to try to get extra returns by owning bond funds that leaned more into credit risk. But that doesn't provide the same defensive characteristics you really want in your bond fund, when your equities are really falling off a cliff. So, we really, I think, appreciate just how stable their bond funds can be within the context of their portfolios. I think this series is one if you really want the active management risk--this is a series that will totally deliver that at a reasonable fee for a low minimum investment.

Dziubinski: And then lastly, your last pick sort of combines the two, some active and some passive strategies.

Kephart: Yeah, active or passive doesn't have to be an all-or-nothing decision. Thoughtfully built portfolios with high-conviction active managers, and cheap index funds where you don't have high conviction makes a lot of sense. Pimco RealPath Blend does this pretty well. It uses Vanguard Index Funds for its entire equity allocation, and it uses its really well-regarded in-house bond funds for the fixed income. It's almost like a match made in heaven.

Dziubinski: Jason, thank you so much for your time today. I think you've given our viewers a bit of food for thought regarding what they could be doing with their IRAs this year. We appreciate your time.

Kephart: Thanks for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.