Is Your 401k Riskier Than You Think?
Meg Handley

What you need to know about target-date funds before you invest

Target-date funds sound simple and straightforward: an investor picks the fund closest to his or her desired retirement date and leaves the asset allocation and rebalancing decisions to experienced fund managers. But because of the stinging losses these funds suffered in 2008's financial crisis -- the average target-date fund lost almost 34 percent -- investors and even the U.S. government have been questioning the transparency and marketing of these popular 401(k) products.

"It was kind of a perfect storm," says Eric Endress, investment analyst at CBIZ Financial Solutions, a national financial services and consulting firm. "All of these employers were taking [target-date funds] up and they were really rapidly growing in the marketplace. Then 2008 happened before these products were really ironed out and marketed properly."

Scrutiny from regulators has increased as a result. A report released in late January by the Government Accountability Office urged the Department of Labor to require 401(k) plan sponsors to assess more thoroughly the appropriateness of particular target-date funds for their employees. The GAO also suggested better education for investors on the strategy, composition, and risks of these funds.

"A lot of people almost viewed [target-date funds] like they were guaranteed accounts," says Endress. "People were thinking, 'Okay, if I'm in the 2010 account, I'll be guaranteed not to lose money between now and 2010,' when in fact that wasn't the case."

That gap between perception and reality, coupled with wide variations in fund composition and performance history, has muddied the target-date waters further, causing some investors to take on outsized risk for their retirement and financial goals. "There was an assumption that an investor would have a very conservative portfolio at the target date," says Susan Viston, portfolio specialist at ING Investment Management. "That wasn't always the case. It became clear that [target-date funds] have very different philosophies and approaches that can lead to different allocations and wide performance dispersions."

U.S. News talked to the experts to find out how you can avoid surprises in your target-date fund.

Know the glide path.

The trademark feature of target-date funds is a built-in asset allocation model -- the so-called glide path -- designed to automatically shift from a more aggressive strategy to a more conservative tack as the investor's retirement target year approaches. For example, while a fund with a target date that's 40 years in the future, such as T. Rowe Price Retirement 2050 (symbol TRRMX), might have a stock allocation of almost 90 percent, funds with sooner target dates tend to back off from equities and allot more money to traditionally less volatile asset classes such as bonds. T. Rowe Price's Retirement 2015 fund (TRRGX) has comparatively fewer assets in stocks -- about 65 percent -- and a heavier allocation to bonds, about 29 percent.

However, wide variations in glide-path structure among fund families have produced very different results, especially for investors closest to retirement. "Some of the target-date providers had allocations to equity between 50 and 65 percent, while others had as low as 30 or 20 percent [at the target date]," Viston says.

Not surprisingly, more conservative funds fared better in 2008's harsh bear market, while investors with more aggressive funds lost almost half of their portfolio's value in some cases. "What a number of firms found was that their allocations to stocks were a little too high and led to losses in a market like 2008 that were greater than they or investors had anticipated," Morningstar analyst Josh Charlson says. "That has led to some shifts in the glide paths, lowering the stock weighting around retirement and actually raising it in the years farthest out from retirement to up the ante and try to get more gains earlier."

Understand "to" vs. "through."

All target-date funds have an associated retirement target year, but some manage to a fund's target date and others manage through the target date. When a fund is managed to the target date, it reaches its final asset allocation at the target year, while funds managed through the target date will continue to evolve after reaching the target year. "To" funds generally assume investors will cash out and move money elsewhere, either rolling over funds to a 401(k) or purchasing an annuity, while "through" funds continue to evolve to generate income for investors in retirement.

These two approaches have differing impacts on the resulting glide path, most apparent nearest to the target date. "What you see with different glide paths between competitors is that the widest dispersion in equity allocation happens at the retirement date due to the difference between "to" and "through" managers," Viston says.

According to a March 2011 Morningstar survey of 41 target-date funds, "to" and "through" funds have nearly identical stock allocations 40 or more years from retirement -- about 90 percent -- but as the retirement date approaches, differences start to crop up. "To" target date funds generally move more rapidly to the lower final equity allocation, while "through" funds have a more gradual arc in equity reduction. At the target date, "through" funds averaged around 49 percent in stocks, while "to" funds had only 33 percent. (The report does note that some "through" funds eventually end up at a lower equity allocation than "to" funds, but it takes longer to arrive at that point.)

Currently, more funds use the "through" paradigm, but Charlson says one approach isn't necessarily better than the other; it depends on an investor's unique situation and financial goals. Because "through" funds have higher equity allocations for a longer period of time, they tend to court more market risk and might expose investors to short-term losses if market upsets like 2008 occur close to the target date. "To" funds, on the other hand, might not have enough equity exposure to generate the level of income retirees need. "One may fit a particular risk profile or investor profile better than the other, depending on your views or intentions during retirement," Charlson adds.

Look under the hood.

Despite being considered by many as one-size-fits-all investments, not all target-date funds are created equally. "[Target-date funds] are a different vehicle -- they're not your average stock mutual fund or bond mutual fund," Endress says. "They're much more complex, even though they are simple from a turnkey standpoint. When you actually look at the components across the different fund families out there, there are a lot of differences."

After the devastation wreaked by the financial crisis on U.S. stocks and bonds alike, some firms have tweaked target-date fund holdings to include more non-traditional asset classes such as real estate, foreign debt, and bank loans. Not only does this provide broader diversification, many of these asset classes have less correlation to U.S. equity and bond markets. "We've definitely seen some shifts," says Charlson. "It's not an overwhelming or universal trend, but it's definitely there. There's a movement towards greater risk control."

While changes have been incremental thus far, Endress notes that recent pressure from regulators and investors might signal more significant changes for target-date funds in the future. "I think we'll see more things come out in terms of regulations moving forward," he says. "[Fund companies] are still trying to find a standardized way to communicate these products and make it simple for investors to understand the differences a little bit more than they do today."

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