The Trouble With Target-Date Funds
By: Jeff Brown

Target-date funds got a tongue lashing at a recent hearing in Washington, as regulators questioned why funds that were to become safer as retirement dates approached still managed to suffer huge losses.

In fact, many of these funds did exactly what they were supposed to do, though not what poorly informed investors had expected.

Whether target-date funds belong in your portfolio depends on a lot of factors beyond recent performance, including your willingness to pay fees and your ability to manage your asset allocation yourself.

While they can be used for any purpose, most target-date funds are meant for retirement or college savings, where the investor expects to begin withdrawals at a specific date.

If you invest in one of these funds 20 or 30 years before you retire, most of your money will go into stocks, which offer higher long-term gains than bonds and cash. In theory, you have time to ride out the stock market’s downturns.

As your target date approaches, more of your money is shifted to bonds and cash, to emphasize safety over performance. That way, you don’t have to worry about a stock-market downturn just as you want to begin taking money out in retirement. Many target funds invest in other funds that specialize in stocks or bonds.

It’s now apparent that many investors incorrectly assumed these funds guaranteed there would be no losses once the retirement date got close.

They were terribly disappointed. Last year the average 2010 target-date fund lost 23 percent, according to market-data firm Morningstar Inc. (Stock Quote: MORN). The worst-performing 2010 funds lost 41 percent.

While the average loss of 23 percent shocked investors, the Standard & Poor’s 500 stock index lost 37 percent. By owning bonds, which were not hit as hard as stocks, the average target-fund succeeded in its goal of softening the blow that hit the fund’s stocks.

But why own stocks at all if the 2010 target date was so close? Mainly because the fund managers assume investors will pace their withdrawals over many years of retirement. The funds therefore continue to hold some stocks, trying to get enough growth to offset inflation.

Vanguard Group’s Target Retirement 2010 Fund (Stock Quote: VTENX), for instance, had about 52 percent of its holdings in stocks at the end of May. It lost 20.7 percent in 2008 and has gained 4.4 percent this year. Its expense ratio is 0.19 percent.
Meanwhile, the T. Rowe Price Retirement 2010 (Stock Quote: TRRAX), lost 26.7 percent in 2008 and is up 8.7 percent this year. Its expense ratio is 0.61 percent.

The chief difference in the two funds: the asset mix. The T. Rowe Price (Stock Quote: TROW) fund is more aggressive, with 58 percent of it’s assets in stocks.

One reason investors were so shocked is that target-date funds are very common in work-based retirement plans like 401(k)s. In fact, many plans use these funds as “default” investments automatically chosen for employees who do not stipulate something else.

Since many of these investors are not paying much attention to their holdings, it’s not surprising they underestimated the risks of target funds.

Whether target funds make sense for hands-on investors is debatable. It is convenient to have fund managers automatically adjust your asset allocation as you age, But it’s important to read fund materials closely to see of the asset allocation strategy they’ve designed for the masses is really suitable for you.

Another issue is fees. Target-date funds typically tack a management fee on top of the fees already charged by the underlying funds.

Use the Compare Savings Rates Calculator to see how higher fees erode returns. Start with an assumed investment return and subtract the expense ratio. A fund gaining 8 percent a year would actually return 7 percent if the expense ratio were 1 percent, while it would return 7.8 percent if expenses were 0.2 percent.

Finally, there’s a matter of conflict of interest. Many target funds invest in other funds offered by the same company, even if competitors’ funds might be better.

Savvy investors can probably do better by managing their own changes in asset allocation. People who want to enjoy the convenience of target-date funds should realize they are not risk free, and that higher fees will chew returns.

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