What the Best 'In-Retirement' Mutual Funds Can Teach You

Jason Stipp: I'm Jason Stipp for Morningstar. Most of the assets in target-date funds are in products geared toward investors who are accumulating assets for retirement, but most target-date series also include an in-retirement option. Here to talk about the intelligence that investors can glean from these in-retirement-income funds is Morningstar's Christine Benz, our director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, it's great to be here.

Stipp: So, how do these in-retirement funds work? Do all target-date series turn into an in-retirement income fund at the end?

Benz: Well, there are different strategies in play. With some of them, yes, indeed, that's what happens. So, if you are holding the 2015 fund, you are coming into retirement. If you just sit tight in a 2015 fund, it gradually transitions to a more conservative-retirement-appropriate mix.

In the case of other target-date lineups, it works a little differently. Let's use Vanguard's lineup as an example. What happens is that all of the target-date funds, once they hit their target date, are then merged into the firm's retirement-income fund. So, you need to pay attention and see what's happening with that end date--what will happen to your fund at that time.

Stipp: Another thing that can happen as that end date approaches is that some target-date funds will say they've taken you to retirement and others will say now we're going to take you through retirement. What is the difference between the [to-retirement and the through-retirement] versions of target-date funds?

Benz: This is a key distinction among these target-date series. With the to funds, they may be using an asset-allocation mix that's gradually getting less aggressive as time goes by, and then it just sort of flat-lines--it stays the same--once the person hits the target date and enters retirement. Some of them, particularly some of the older-style products, were managed to kind of deliver a pile of cash to the retiree upon retirement. So, they were managed to become very, very conservative once that target date approached. That's sort of an older style of to funds. The through funds are managed as though the retiree will hold them through retirement, and that asset-allocation mix, in general, in the through funds becomes more and more conservative as the retiree goes on through his or her retirement years.

Stipp: Do we know where most investors are in these target-date funds? Are there more people in the through funds now because it's a newer version of those funds?

Benz: In terms of number, there are a few more through funds at this point. I checked in with Jeff Holt who focuses on target-date funds and in-retirement-income vehicles specifically. He said the preponderance of assets in retirement-income vehicles or in target-date series are in series that use a through approach. So, the idea is that that asset allocation will be actively managed through retirement and will become progressively more conservative.

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Stipp: So, forretirees who are managing their own portfolios, it sounds like this distinction on what kind of target-date fund you have--to or through--would be very important?

Benz: It absolutely is. For retirees who want to look at target-date funds as perhaps a model for what they should be doing, it's really important to keep in mind what their plan is for their retirement-savings kitty when they hit retirement. If my plan is to go out and buy, say, an annuity once I hit retirement, then maybe it would be appropriate for me either to use a to fund or use a to approach with my own asset allocation where I want to get very, very conservative as I get closer to making that purchase. For other investors, though--I would say for most investors--they're probably going to hang on to at least a portion of their retirement portfolio through retirement. That means that they want to hold perhaps some cash to meet near-term living expenses, but some bonds and stocks as well.

Stipp: Because, as we know, retirement can be a multidecade proposition.

Benz: Absolutely.

Stipp: You recently looked at a variety of sources of these target-date funds and some other sources to get a temperature check on what the different kinds of allocations at this retirement point look like. Let's start first with the Morningstar Lifetime Allocation Indexes. What kinds of allocations do you see there at the point of retirement?

Benz: There is a gamut. The Morningstar Lifetime Allocation Indexes are geared toward conservative, moderate, and aggressive investors. The conservative retirement-income index is, as you would expect, very equity light--about 20% in stock holdings. The aggressively positioned retirement-income index does contain a higher allocation to equities--nearly 40%. And as you might imagine, the moderate index falls somewhere in between--right about 30%, in terms of its equity exposure. It's also important to take a look under the hood--look at the intra-asset-class exposures. In keeping with some of Morningstar Ibbotson's research on how intra-asset-class exposure should change through retirement, what you see is pretty high allocations to Treasury Inflation-Protected Securities within the retirement-income indexes.

As a percentage of fixed income, the TIPS are about 30%. And what we also see is that the international-equity exposure drops down pretty significantly for the retirement-income indexes. So, for young accumulators--maybe people retiring in 2055 or 2060--we've got roughly 40% of total equity exposure is international. For people who are in retirement, what we see are allocations to international equity that are just about 20% of [total] equity exposure.

So, that's something to keep in mind. The basic idea there is that people need more inflation protection when they're retired. So, they need more TIPS and they need fewer fluctuations in terms of their principal value. Those fluctuations often accompany foreign-currency exposure and foreign-stock exposure. That's why it goes down as a percentage of the equity allocation.

Stipp: So, some interesting sub-asset-allocation detail there. When you're looking across the different mutual fund providers with target-date series for the retirement-income funds, what kind of range do you see?

Benz: On average, the equity exposure is right around 30%. Right in line with Morningstar's moderate lifetime retirement-income allocation index. So, it's pretty middle-of-the-road in terms of that exposure. The rest of the retirement-income portfolios are in cash and bonds--and varying weights in cash relative to bonds.

Stipp: We have a few target-date series that we really like. One of those is the Vanguard target-date series. If you're looking at their version of the income fund, what is that allocation?

Benz: That allocation is right about 30% for the equity allocation. The interesting thing, I would say, in terms of the exposures within the Vanguard product is that it has a pretty high allocation to international bonds, and that's a relatively new phenomenon across Vanguard's target-date series. They have laid in that 20% of fixed income is going to international bonds. That holds true for the retirement-income vehicles as well. They do also include a fairly sizable allocation to TIPS--about one fourth of the total fixed-income allocation is in Treasury Inflation-Protected Securities.

Stipp: In the international bonds in Vanguard, do they hedge the currency exposure or not?

Benz: They do. Vanguard is very attuned to the fact that owning some sort of an unhedged foreign-bond portfolio would give you a lot of currency-related volatility. They want to try to keep that out. They think that they found a fairly low-cost way to give investors a little bit of the extra diversification that can come along with foreign developed-markets bonds without all of those foreign-currency fluctuations.

Stipp: T. Rowe Price is another target-date series that we like, but it varies a little bit. What does their allocation look like for the retirement-income vehicle?

Benz: In keeping with what goes on with the target-date funds geared toward accumulators, what you have here is a fairly high allocation to equities. So, even for the T. Rowe Price retirement funds geared toward people who retired in 2005, what we see is a 40% equity weighting overall. That's a fairly high weighting. What you also see is that because T. Rowe is primarily an actively managed shop, they've got little slices of various asset classes--of various small-cap funds, for example--that appear in the retirement-income funds. They also have international bonds here as well.

So, some of the more niche asset classes appear in the T. Rowe Price portfolios, including the retirement-income portfolios. This is based on T. Rowe's research that shows that for many retirees, they spend more in retirement than they expected to and they have a greater risk of running out of money. So, they keep those asset allocations pretty aggressive even for people who are already retired.

Stipp: We see some interesting variations here between the Morningstar Lifetime Allocation Indexes and some of the mutual fund target-date series at that retirement-income time. As an investor, if I'm managing my own portfolio, how should I take this information and apply it?

Benz: It's a good question because I think what you see with these funds is that they are blunt instruments. They will not fit many situations. I think a great example would be, say, the retiree who is lucky enough to come into retirement with most of his or her income needs being met with a pension and Social Security. That person could arguably run with a much more aggressive, more equity-heavy mix than anything we've talked about here. And here, I think it does get back to that bucket approach of really thinking about your cash flow needs from your portfolio and segmenting it accordingly. So, if you are drawing very lightly upon your portfolio--maybe you are just using it for fun expenses or things that come up within a given year that weren't necessarily planned--you can arguably hold less in cash, less in bonds, and much more in stocks.

Stipp: So, investors doing it themselves will need to take somewhat of a tailored approach, but they can use some of this interesting data in finding just the right approach that will work for them in retirement.

Christine, thanks so much for joining me.

Benz: Jason, nice to be here.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.