What you need to know about target funds

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Kathy M. Kristof

Apathy and neglect can be benign forces in the investing world. Need proof? Look no further than target-date funds.

These set-it-and-forget-it investments — which annually adjust their holdings among a variety of investments in order to prepare shareholders for a particular year of retirement — have become ubiquitous in 401(k) plans since 2007. That’s when employers were granted the right to use them as a default choice for workers who neglected to pick an investment option for their accounts.

But if you’re one of those passive target-fund investors, you’d be wise to get up to speed as you slide toward retirement. After all, once you clock out, you’re not bound to remain in the fund your employer picked for you.

And even though the funds all have the same purpose, different funds with the same target retirement year can have widely varying notions of what constitutes a bull’s-eye. The closer you are to needing your savings, the more important those differences become.

Nothing illustrates the point like the actual performance of target funds when the market tanked in 2008. The 31 funds with a 2010 target date lost about 25 percent, on average; but some had losses as great as 41 percent (worse than the overall stock market’s 37-percent plunge), and some lost as little as 4 percent.

That real-life experience was a wake-up call for both investors and regulators. Congress subsequently held hearings, and the Securities and Exchange Commission tinkered with the rules to rein in some outliers and require better disclosure. But there are still important differences among the funds.

How target funds work

What’s true for all target funds is that they invest in a mixture of stocks, bonds and cash (and sometimes in commodities and other asset classes as well).

The mix of investments varies over time, starting out with aggressive, stock-heavy allocations when investors are young and far from their target — usually an anticipated retirement date — and becoming increasingly conservative as investors get older and closer to their goal.

But how funds define conservative is inconsistent. Exposure to stocks — the main cause of volatility — ranges from 55 percent to 10 percent among funds that have reached their target date and are thus catering to those who are already retired or nearing retirement, said Sasha Franger, an analyst at Lipper, a fund research firm.

The explanation: About 35 percent of target funds expect to get you to retirement; the remaining 65 percent expect to help you through retirement.

Those just getting you to retirement assume that you’ll need the bulk of your assets right away, so they become conservative about five years before the target date. Those with a get-you-through approach become conservative far more slowly — often over the course of another decade or two.

Some funds follow both approaches. For instance, Deutsche Bank’s series of exchange-traded db-X target-date funds are by far the most conservative for near-retirees. By the time these ETFs reach their dates, the allocation to stocks drops to 10 percent.

However, the db-X funds that have hit their maturity date don’t remain conservatively invested for long. A year after a fund reaches its target date, the portfolio starts shifting back into stocks.

Why the reversal? DB figures that people who leave their money in the target fund for more than a year after retirement probably don’t need the cash immediately. So even though the original intent was to get you to retirement, the money that stays will be invested through retirement.

Some are more aggressive

By contrast, T. Rowe Price has a large stock position at the target date — some 55 percent of the portfolio. Over the next 20 years, the fund company will ratchet stock-market risk down to 20 percent before the fund’s so-called glide path levels out.

This aggressive approach is based on two assumptions. The first is that investors are likely to withdraw assets slowly over a course of 20 to 40 years in retirement.

The second is that a short-term loss isn’t the worst risk that investors face in retirement. The bigger risks are longevity and inflation, which could cause investors to run short of money before they run out of breath.

By keeping the portfolios more heavily invested in stocks during the early retirement years, the funds’ returns are more likely to beat inflation and provide more buying power for retirees later on.

Both Vanguard and Fidelity — the industry’s two top players — fall somewhere in the middle. Both have glide paths that would have investors at about 50 percent in stocks at retirement. Both gradually move assets into a more conservative mix over the next several years.

At the point that the fund managers stop making age-related adjustments — at about seven years after the target date for Vanguard and 15 for Fidelity — they automatically shift investors who remain with their target-date funds into retirement-income funds. Such funds invest the bulk of their assets in fixed-income products and commodities to protect against inflation.

For investors, the best advice is to consider what you need from a target fund. If you’re more worried about market volatility than long-term returns, look for a fund with a conservative mixture of assets from start to finish. If you can handle some volatility, look for a more-aggressive fund.

Kathy M. Kristof is a contributing editor to Kiplinger’s Personal Finance magazine.
© 2012 Kiplinger’s Personal Finance