Saving for retirement: Do target date funds miss the mark?

Target date funds are popular for investors who prefer to "set it and forget it" when it comes to their retirement, but even funds with the same target date can carry very different levels of risk. Ask the right questions before deciding how and where to invest.

Target date funds are a popular way to set retirement investments on auto-pilot. Also known as age-based funds or life-cycle funds, investors can simply pick a target date (the year they plan to retire), and the mutual fund automatically resets the asset mix (stocks, bonds, cash equivalents) according to the time frame.

If you plan to retire in the year 2040, for example, you'd pick a 2040 fund. When an investor is young, the mix is riskier and more aggressive, since there are enough years to recover losses. As the investor nears the target date, the asset mix becomes more conservative to ensure that the money will be there for retirement. Typically this means that the funds shift from a mix with more stocks to a mix with more bonds and cash.

All target date funds not alike

It sounds like a convenient way to put aside money for your golden years, but the problem is that all target date funds aren't alike. One might think that all 2040 funds should be similar in terms of risk level, but as Tim Grant writes in the Pittsburgh Post-Gazette, target date funds can vary substantially in their "glide path," which is the ratio of stocks, bonds, and cash:

A comparison of target date 2015 funds conducted this year by Morningstar showed that the AllianceBern 2015 Retirement fund had an allocation of 71 percent stocks, 28 percent invested in bonds and 1 percent cash; Oppenheimer Transition 2015 had a mix of 65 percent in stocks, 24 percent in bonds and 11 percent cash; and the Vanguard Target Retirement 2015 fund was 60 percent stocks, 37 percent bonds, 3 percent cash.

During the 2008 financial crisis, target date funds were hit particularly hard. Investors with a target date of 2010 lost 24 percent on average, according to the Securities and Exchange Commission (SEC), with some investors losing as little as 9 percent or as much as 41 percent. Investors believed they had enough money for retirement and a sound investment strategy, but they were more exposed to risk than they realized because they had no idea how or when the fund changed its glide path.

Are new rules enough?

In June 2010, the SEC proposed new rules that would provide investors with more information about their target date fund. The rule changes would "enable investors to better assess the anticipated investment glide path and risk profile of a target date fund by, for example, requiring graphic depictions of asset allocations in fund advertisements."

While most view the proposal as positive, others feel that it's not enough. One concern is whether target-date funds should continue to be qualified default investment alternatives, as designated by the U.S. Department of Labor. When an employee has not made an investment choice with their 401(k), employers can invest the employee's contributions in a target date fund, and the employer is protected from liability.

Investigate before investing

Target date funds still are a great option, but don't be lulled into taking a hands-off approach with them, or any other investment. Just as it's important to compare CD rates and money market rates, it's important to compare funds. The Securities and Exchange Commission recommends that investors do the following before investing in a target date fund:

• Consider your investment style. How active do you want to be in managing your retirement? If you don't want to invest much time in it, a target date fund might be a good solution, however, you should still pay attention to the fund's asset mix.
• Look at the fund's prospectus to see where the fund will invest your money. Make sure you know the strategy and risks of the target date fund.
• Understand how the investments will change over time. Do you know when the fund will hit its most conservative investment mix? Some target date funds reach their most conservative mix at the target date, while others may not until 20 or 30 years after the target date. Assess your personal tolerance for risk to decide if the fund is right for you.
• Take into account when you will access the money in the fund. Do you plan to withdraw your money at retirement, or continue to invest? How do your plans fit with the investment mix at the target date?
• Examine the fund's fees. Funds with the same target date may have different investment results and charge different fees. The fee differences might seem small, but they can affect your returns over time.

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