Target-Date Funds Reset Their Sights

From U.S. senators to government regulators to shell-shocked investors, everyone, it seems, is drawing a bead on target-date funds for producing such rotten results during the 2007-09 bear market. These funds were supposed to be simple solutions for retirement saving: You picked a fund with a date close to your anticipated retirement. As the date approached, the fund would adjust the bond portion of its portfolio to become more conservative and protect returns.

But that’s not exactly how it worked. Take 2010 funds, for example, which were designed for investors at or near retirement now. On average, those funds lost 34% of their value during the bear market. That was still better than the 55% drop in Standard & Poor’s 500-stock index, but it was a big hit for investors in the critical first years of retirement.

And because each family of target-date funds has its own mix of assets -- and follows its own so-called glide path when shifting to more-conservative investments -- fund performance varied considerably. For instance, the worst-performing 2010 fund, Oppenheimer Transition, had 66% of its portfolio in stocks, plus a big bond holding that tanked. As a result, it posted a decline of 54%. But Wells Fargo Advantage Dow Jones Target 2010 had just 25% of its assets in stocks. It lost only 19% during the same period (see the table below).

Full disclosure

Those results prompted the U.S. Senate, the Securities and Exchange Commission and the Department of Labor to pile on with hearings investigating the use of target-date funds in retirement plans. Let us be upfront about where we stand: We have always liked target-date funds and still do, even when they invest aggressively (within reason) in stocks. Some lawmakers have pushed for regulators to establish asset-allocation guidelines for the funds. We disagree -- that’s a job for fund managers. But investors do need to know what’s in these funds and how best to manage them as part of their overall investments.

That’s especially true because target-date funds are popular default options in retirement plans. If you don’t choose your own investments in a 401(k) plan, for example, your employer may deposit your contributions into a target-date fund. Congress permitted this with the Pension Protection Act of 2006, and since then the number of plans that automatically funnel 401(k) contributions into target-date funds has more than doubled. According to Vanguard, one of the three largest providers of target-date funds as measured by assets, the percentage of plans it manages that use these funds as default options grew from 42% in 2005 to 87% in 2008. Fidelity, another top target-fund sponsor, experienced a similar pattern in the plans it manages.

And target-date funds may blossom into something even bigger because younger workers are more likely to own them. Casey Quirk, a consulting firm, projects that money in target-date funds will grow 11-fold, to $2.6 trillion, by 2018. The firm assumes that target funds will attract 80% of the new money going into retirement plans over the next decade. At the end of 2008, 43% of retirement-plan participants in their twenties owned these funds, up from 29% in 2007, reports TD Ameritrade. That compares with just 22% of savers in their sixties.

But many investors don’t understand how target-date funds work. A recent study by Envestnet Asset Management and Behavioral Research Associates found that only 16% of investors had even heard of target-date funds. Of that group, 62% thought they would be able to retire when the fund reached its target date, and 38% thought their fund had a guarantee.

Target funds were designed to be the only investment you’d need for retirement. But people rarely use them that way. Only 19% of investors put as much as 80% to 100% of their assets in a target-date fund, according to a survey by AllianceBernstein.

And there’s another sticking point: A fund’s glide path doesn’t necessarily stop when you expect it to stop. Instead of ending in, say, 2010 or 2030, all of the major target-date funds continue to increase their bond allocations decades after the target date. “If it’s a 2030 fund, the glide path should end in 2030,” says Michael Case Smith, target-date portfolio manager at investment firm Avatar Associates. Fees also remain a concern. Some sponsors charge a management fee on top of expenses levied by the underlying funds in the target-date portfolios.