Target-date funds, billed as confidence-building vehicles that gradually shift your holdings into more conservative fixed-rate instruments as their date nears, have caused some sleepless nights.

Investors stashed money in these one-stop retirement plans so they didn't have to worry about making their own allocation decisions. But it has become clear they need to better understand the basic concept of target-date funds and carefully scrutinize any fund under consideration.

The 2010 target-date funds designed for people who turn 65 years old next year lost an average of 25 percent of their value in 2008. Since many target-date funds are also the automatic default investment for enrollees in company 401(k) retirement accounts, the devastation was compounded.

As funds were drawing close to that target date, encouraged by a vibrant stock market, they kept a lot of stock in their portfolios. They were also competing for the best performance in order to attract new assets. But then the bull turned into a bear and they paid a high price.

The average 2010 target-date fund had a 45 percent stock allocation at yearend 2008, according to Target Date Analytics LLC in Marina del Rey, Calif.

"The fund companies had expanded their investment strategy past the target date, using the rationale that people live 15 or 20 years past retirement, so they should keep a strong equity position," said Joseph Nagengast, principal with Target Date Analytics. "Target-date fund managers weren't managing to the year 2010, as some investors assumed, but to some point well beyond it."

Investors must determine whether a target fund they're considering is a "to" fund that manages the money to the target date or a "through" fund that manages it past the target date and well into retirement, he said.

"Ask the fund company when the fund will reach its most conservative position," advised Nagengast. "If it's a 2030 fund and they tell you 2029, you know they're managing to the target date, but if they say 10 years after that date, you'll know they're managing well into retirement."

That means more responsibility than most target-date investors expected.

"You as the investor must define the target date and whether it represents when you plan to retire or some date beyond that," said Jack VanDerhei, research director for the Employee Benefits Research Institute (EBRI) in Washington, D.C. "A lot of people believe that by the target date they should be down to zero equities, which indicates their lack of understanding."

Some fund companies that were low on equities last year are now trumpeting their lack of negative performance, VanDerhei noted, while others are saying a certain percentage of equities must be in your portfolio to fight inflation if you have 20 years or more left in your retirement.

"As the investor, you must know which strategy makes you feel most comfortable," he said, noting that reading the prospectus of the fund remains crucial. "Many people say target funds dated 2010 or close to that have too much equity in them, but this ignores the fact that the investor can look for a fund that holds a smaller percentage of equities."

Surveys have shown that some investors incorrectly believed they were getting a guaranteed payout when the target date was reached, another misconception. But despite all the fallout from poor performance and some murky comprehension, there can be a place for target-date funds in an individual's planning if he or she clearly understands what the investment is all about.

"It still makes sense to have target-date funds and, like any other investment, there are good and bad ones," said Greg Carlson, fund analyst with Morningstar Inc. in Chicago. "They provide one-stop shopping for investors who don't want to build their own portfolios, plus broad diversification over most asset classes."

The three biggest competitors in target-date funds are Fidelity Investments, Vanguard Group and T. Rowe Price, though such funds are offered by a host of investment companies.

Carlson especially likes the Vanguard Target Retirement Funds because they're mostly index funds with broad diversification and low fees. He also likes T. Rowe Price Retirement because it has some excellent funds in its portfolio and "is one of the few companies that does a lot of things really well." Two examples of 2010 target-date funds Carlson finds noteworthy are Vanguard Target Retirement 2010 (VTENX) and T. Rowe Price Retirement 2010 (TRRAX).

Other experts have caveats about even those fund groups.

"I think Vanguard and T. Rowe Price do a good job in long-dated funds that have more than 20 years until the target date," said Nagengast. "But in my view, they do a poor job of managing risk in short-dated funds of 15 years or less because they're making investment decisions based on a date well past the actual target date."

Whatever fund company and fund is chosen, individual investors still bear the ultimate responsibility for the selection made. The buck stops with them.

"All the big fund companies are pretty competitive on fees, so I don't think that will be the greatest factor making an investor choose one company over another," concluded VanDerhei. "It really comes down to asset allocation and which fund company you feel most comfortable with."

 

 

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