031: Target Date Funds And Age-Based Investing
Sep 23, 2020
We are all living in one of the craziest, most volatile markets in history. To get through it, you need a plan, and that plan needs to change over the course of your life to ensure you conserve when you need to, have cash flow, and can make transitions with confidence and ease.
These are the core concepts of age-based investing – looking at risk as part of your plan to achieve safety, income, and growth.
Today, we explore target date funds and how to use them as you age to reduce your risk over time and meet your financial targets, no matter what happens along the way.
Here are just a handful of the things that we'll discuss:
- The three basic places to put your money – and how to think about all of them as you age.
- How to use target date funds effectively – and how you can use the 2008 financial crisis to understand the common misconceptions surrounding these assets.
- Why everything in the market has risk.
“What you need most in the market, is time.” – Ed Siddell
LeAnne Siddell: It's The Retirement Trainer with Ed Siddell, a podcast about finding ways to help you become financially fit for your future no matter what financial shape you're in now. What are target-date funds? What is the concept of age-based investing? And why is it important to understand? And lastly, does it make sense? This is LeAnne Siddell, and here to help us with all of our questions and to give us some guidance to help us stay in the best financial shape possible, The Retirement Trainer, Ed Siddell.
Ed Siddell: Ola.
LeAnne Siddell: Hey. Okay. So, right now, this is a crazy, volatile market that we're dealing with. Age-based investing, what's the purpose?
Ed Siddell: You know, well, to summarize it, conservation, cash flow, and confidence as you transition enter that whole new phase in your life.
LeAnne Siddell: Well, alright. For the everyday person out there, let's back that up. What does that mean?
Ed Siddell: Alright. So, age-based investing is really designed to the younger you are, the more aggressive you are, and the older you become as you enter that new phase and transition into retirement, it's designed conceptually to make it more conservative for you. I mean, we use the concept here at EGSI. I mean, we use the concept as part of our retirement fitness plan. And that concept of the age-based investing as part of looking at the risk and as part of the overall plan, we call it safety, income, and growth. And so, when we talk about it, there are three ways, three places to put your money and it's really simplified. You have the money that you need for safety. You need the money that's for income, that's also conservative. And then you also have the money that you're going to need for growth. So, when we talk about growth, that's going to be everything that's on the stock market, stocks, bonds, mutual funds, exchange-traded funds, everything that's adjusted to the market. Then we talk about the income bucket that's also conservative that's going to be where you're going to be drawing income from when you're retired, which is Social Security, your pensions, annuities because a pension is really just an annuity.
Dividend income, interest income, and also bonds, I had bonds on both sides because you have conservative bonds like AAA-rated, US treasuries, short-term, and then you have the high-risk debentures, which is really a bond is a debt instrument. And some are not investment grade. They're actually called junk bonds but people invest in those right now to get a higher yield so that's why we have in both places. And then you have the money that you need that's for safety. So, for safety, it has to meet two requirements. It has to be liquid and assessable. So, it has nothing to do with return. And it's really about your emergency funds. Whether it's us or Suze Orman, Dave Ramsey, whoever it is, the industry agrees that you should have between 6 to 12 months cash reserves set aside, especially when we're going through times like we're going through today, right?
LeAnne Siddell: Yeah.
Ed Siddell: When we talk about growth, so you know you've got to have 6 to 12 months cash set aside for safety, for emergency funds. So, how much do you stick in growth? And it is the concept of age-based investing. We use the prudent investor rule where you take your age, you subtract it from 100 and that percentage. So, let's just say that you're 65 and you subtract that from 100. Based on this concept, that means you should never have more than 35% as you transition into retirement at risk in the market. Okay. In the example, we use our kids all the time, right? So, when our kids were born, we were very aggressive investing in high-risk stocks, because we were wanting that growth and we could deal with the risk because we didn't need the money for a long period. But that summer before high school, we started pulling chips off the table and started getting more conservative and even moving some new cash. And each year as they got closer and closer to that first year of college, we had a very conservative high cash position. And the reason is if the market tanks where you hit a recession, whatever it is, we wanted to make sure that we had enough money to fund college.
And we didn't want to be in a situation where we had to sell things at a loss, just be able to cover those college costs. And we'd be able to cover maybe the first two or three years but eventually, you'd run out of money. And it's the same concept when it comes to retirement. So, when we're talking about target-date funds, I mean, it’s that same kind of concept, but it's completely different.
LeAnne Siddell: And this can lower your risk.
Ed Siddell: You know, it can if it's done the right way. It can lower the risk because it's designed the older you are, the more conservative we're supposed to be. So, let's kind of move into the target date funds and explain the target date funds and how they work and I think it'll make a little bit more sense. So, when we talk about a target-date fund, it's a tool. All right. It's really no different than a stock, a bond, a mutual fund. And that's really what it is. It is a mutual fund. So, it's a fund to funds and they're really all different. The concept is that they call it a glide path. That's the industry term and it really doesn't make a whole lot of sense but if you think of it based on your age, it hits different parameters. So, if you're in your 20s to early to mid-50s, it's about the accumulation phase of your life. And you're really looking for long-term growth. You're not as concerned about the ups and downs and the volatility in the market. And that's what volatility is, the ups and downs. And so, you can afford to be a little bit more aggressive because you don't need the money.
LeAnne Siddell: And that's where that whole interest, I hear you say it all the time when you talk to people, you talk about what you need most in the market, you need time.
Ed Siddell: Yeah. I mean, that's it. So, the growth, right, when we were doing safety income and growth, you have to have money in growth. You just have to, to hedge against inflation, and healthcare, legacy planning, and you need growth, but you do, in time, which is that depleting asset. And so, you need enough time for it to recover that you're not going to have to touch the money. And so, I think of that, that's right, that's that accumulation phase. And then you have that preservation phase. When target dates look at this, they're saying early to mid-50s, as you're getting ready to enter that last phase of your life, which is distribution from a retirement perspective. And so, it's more conservative, it's about more consistent growth, and it's much lower risk. And then the last phase, so this was the glide path, right? The last phase is the distribution phase and it's about protecting the principal. Because it's all about cash flow, you want to make sure that you reduce the risk even more, and you want steady growth. And that's really how they're looking at it because when you retire, it's all based on cash flow, and it's the amount of money that you need to live on, and how much you have to withdraw.
And so, the more you withdraw, whatever that percentage is, it used to be before the tech bubble hidden in the early 2000s, 2000-2001. The rule was, as long as you pulled out 6% or less of your money, those earnings, you would never run out of your principal. Well, once the tech bubble hit, then they said, “Oh, no, no, no, that doesn't work because everyone ran out of money.” So, now it's 4%. And once the housing bubble, right, that institutional failure kicked in with the banks, it dropped from 4% to less than 3%, and depending on what you read, it's anywhere from 1.88% to 2.8% is the maximum so we'll just say less than 3%. But that's one thing to say in that, but it's another thing to say, “Okay. Well, I can only pull out 3% and never run out of money,” but can you cover what you need to be able to live and enjoy retirement? Okay. And that's the whole concept with this. So, target-date funds, their whole job is to grow the assets over a very specific period of time and that's why they call them to target-date funds because it's a targeted goal. So, it's really based on your age. So, you could see target-date funds 2015. That means you retired in 2015, or 2020, or 2025, or 2030, or all the way up to I think I just saw they're now coming out with 2070. So, that's projected as to when you're going to retire so it's all based on your age and your working life.
LeAnne Siddell: So, I'm going to throw like the amateur question out to you because I do see a lot of the 401(k)s come in and when I'm looking at them, I can see where somebody who has yet to retire is in a 2015 target fund. Is that because they're attempting to be ultra-conservative.
Ed Siddell: More conservative, yeah. And so, there are misconceptions when it comes to the target date funds. So, the target date fund, it refers to when you're supposed to be withdrawing money from it for retirement. The target-date funds, they're not guaranteed. It does not provide a guaranteed stream of income either. So, that's important to understand. One of the other things that we hear all the time is that, "Okay. Well, it's in a target-date fund, so I can't lose money.” Well, no, there's risk in it because it's a portfolio. It's a mutual fund. It's in the market. Anything that's in the market has risk.
LeAnne Siddell: Exactly.
Ed Siddell: Right?
LeAnne Siddell: Yeah.
Ed Siddell: And here's the other thing is that not all target dates are the same. It's just like a mutual fund. So, from one family, whoever it is, whether it's Vanguard, T. Rowe Price, I mean, they're all different. And that's important to understand. Again, that glide path is designed to help reduce the risk because early on, if you're 40, 30 years out, you're going to have a lot of growth funds inside there because, remember, it's a fund to funds. It's like a portfolio. So, you have growth stocks, value stocks. There's a lot more risk, a lot of international, but the closer you get to retirement, the more fixed income and bonds that you're going to have. And so, the theory is it's going to protect your investments more and more. Now, this was part of going to kind of go down a rabbit hole here, this was introduced in the law as part of the PPA 2006. So, it's the Pension Provision Act of 2006. And it was introduced in the 401(k) plans to give participants a way to protect themselves against market volatility and risk. But it's just like anything else, it's a tool. That's all it is. And so, it needs to be part of a bigger picture. And a lot of participants, they will sign up for a 401(k) plan, and then never pick an investment.
So, as part of the Pension Provision Act, instead of it just sitting there in cash, they have what's called a QDIA, a qualified default investment alternative. And so, what it allows the plan to do is take the funds that you're putting in and invest it for you based on your date of birth.
LeAnne Siddell: So, they automatically are plugging them into a target-date fund.
Ed Siddell: Yep. And that's the QDIA. Okay. So, that default investment is the target date fund in most plans. Not in all but in most plans.
LeAnne Siddell: So, that's where that little if you didn't mark the box, then you're automatically going to be placed in this portfolio according to your age.
Ed Siddell: That's right. That's right. And so, is it better than cash? It depends on your situation. Is it better than having a go into an index like the S&P automatically? Well, it depends on your situation. So, they're looking out for the best interest of the consumer, of Americans to make sure that they're being protected but again, it does not resolve the issue of risk. Because if we go all the way back to 2008, in 2008, and this is what is most astounding, is that the average loss of all target-date funds from all families during that time period was 24%. I mean, that's a chunk of change. And that's important because when we're meeting with families, the families that we're trying to help, one of the first questions that I ask is we're trying to determine risk. In that risk budget, I always say, “Okay. How much money are you willing to lose? How much can you lose and still sleep at night?” Well, what's the first answer that everyone says?
LeAnne Siddell: Zero.
Ed Siddell: I'm holding a zero right now, right? Yeah, absolutely. They don't want to lose anything. But once we develop that risk budget, okay, and we know how much they're willing to lose and then we evaluate their current mutual funds, then we can determine using safety, income, and growth part of the overall plan. How much risk they are taking, how much risk they're willing to take, and how much risk they actually can take?
LeAnne Siddell: That's that whole breakdown that we basically are able to show them exactly where their speed sign is on their 401(k).
Ed Siddell: Yeah, that's right. That's right. And we do. We use speed limit signs so you think of the speed limit sign of one. You're in your driveway with a car on and it's in park. That's like cash. So, there's not a whole lot of risk. It's there and it works but it's not going anywhere. And then the top end is 100. So, I mean, that's a lot of risk. You're going down the interstate 100 miles an hour, top-down your hair on fire, yeah, there's some risk. And just to put it in perspective, the SMP, the stock market, the average is about a 75. So, most of the families that we help, they want to be somewhere between a speed limit sign of 20 to 35 but we do have some that want a whole lot of risk and some are okay taking that 60%, 70%, and other say, “You know what, even at a 20% or, I mean, a 20-speed limit sign, I don't even want to risk 10%, I don't even want to risk 5%.”
LeAnne Siddell: I think what's cool about looking at those speed limit signs, also it gives you based off your overall portfolio, it tells you this is your potential gain and this is your potential loss, and that potential gain might look great, awesome, until you look at the potential loss.
Ed Siddell: Yeah. How much you're going to actually lose. Yeah. And so, when we're talking about loss, and see that's what it is, is when you're looking at target-date funds, it is just a tool. All right. It's not part of the overall plan. And that's really how you have to look at it. You would never use, people hate it when I use it, I think I've actually used this before on the podcast.
LeAnne Siddell: A lot of times.
Ed Siddell: You don't want to use a hammer to cut a piece of wood and you don't want to use a saw to hammer a nail. You've got to use the appropriate tool for the right reasons. And it really has to fit as part of your overall tool. And that risk is so important because people don't even understand. In 2008, the largest loss of a target-date fund was over 41%.
LeAnne Siddell: Yeah. I do think when people see that in their 401(k), they have these visions when they're picking where they're going to be.
Ed Siddell: Safe.
LeAnne Siddell: Yeah, they do. They say, “Oh, this is perfect. It's a target-date fund. This is the date I want to retire. And they're going to make sure that this pot of money is here when I want to retire.”
Ed Siddell: Right. And that's why I wanted to go through and make sure that everyone understood the misconceptions. You know, it's not that they're good. It's not that they're bad. They serve a purpose and you just need to make sure that you're using the right tool for the right purpose.
LeAnne Siddell: And understanding what goes into that target-date fund.
Ed Siddell: Yeah. Because it is a portfolio. Right now, there's a lot of risk around the world. And so, a lot of the target date funds, they're heavy in bonds. So, what kind of bonds are they? You know, are they all AAA-rated? Are they short term? Are they long term? I mean, interest rates are really low, zero in a lot of places. I mean, the feds just announced this week and this is effective as of this date, which is September 18, 2020, that rates are going to be staying where they're at, which is almost zero for the next couple of years. But who knows? So, do you want to get stuck in a long-term bond? Are they all investment grade? Which means it's either junk bond or investment-grade junk bond like we were talking about, as far as growth, the risk. There's a lot of risk in there because now all of a sudden, you're not first in line. You're no longer the bank. You're at the back of the line as far as getting paid if that company goes under. And then you have international. Where internationally are they investing? It's just like any other mutual fund, any other investment, exchange-traded funds, even stock. That's why it has to be part of the overall plan. Again, it's not saying one is good or bad. You just need to make sure that it fits with your overall plan.
LeAnne Siddell: Well, this is the call to action for you now, all those listening, and the call to action is look into what you're invested in. Go see your financial advisor. Give us a call here if you have questions. You can get ahold of Ed by emailing us at email@example.com. It's all great information but if you'd like a copy, we have a copy of what's called 10 Steps of Layoff Survival Guide.
Ed Siddell: Yeah. We just put that together. It's pretty good.
LeAnne Siddell: Yeah. So, again, email us at firstname.lastname@example.org or you can go to our website at www.EGSIFinancial.com or you can give us a call here at the office. We are always so excited to help those that give us a call here at 614-526-4118. Thanks, Ed.
Ed Siddell: Thanks, LeAnne.