Are target-date mutual funds missing the bull’s-eye?

It appears the answer is yes for many of these funds, which are designed to smooth a worker’s path to retirement by automatically resetting the investments as the investor ages.

Typically, a target-date fund changes its asset allocation to become less risky as the investor nears retirement.

But because there are significant differences in the asset allocation of the funds, some of the more aggressive have racked up big losses in the recent bear market and have drawn the attention of regulators and lawmakers.

“The results of excessive risk can be devastating for those on the brink of retirement,” said Sen. Herb Kohl, D-Wis., chairman of the Senate Committee on Aging, which has been investigating target-date funds. “One 2010 target-date fund lost 41 percent in 2008.”

Attention has been focused most on 2010 funds, whose investors are on the verge of retiring.

In 2008, the average loss among 31 funds with a 2010 retirement date was almost 25 percent, said Mary Schapiro, chairwoman of the Securities and Exchange Commission, which is reviewing target-date funds’ disclosure about their asset allocations.

“In addition, varying strategies among these funds produced widely varying results,” she said in a recent speech to mutual-fund executives. “Returns of 2010 target-date funds ranged from a minus 3.6 percent to minus 41 percent.”

What makes target-date funds so crucial is that the Pension Protection Act of 2006 makes it easier for employers to use the funds as default investments in 401(k) plans.

From the end of 2005 to this March, target-date-fund assets increased from $66 billion to $152 billion, peaking at $178 billion in 2007, Schapiro said.

“More than 60 percent of employers now use target-date funds as a default contribution option, compared with just 5 percent in 2005,” she said.

One of the flaws with target-date funds is that they’re designed for a particular age range and don’t consider individual tolerance for investment risk, said Christopher Jones, chief investment officer at Financial Engines, an investment advisory firm that works with companies and 401(k) participants.

“Not everybody is the same when it comes to risk tolerances,” he said.

What’s more, many factors can change the way you invest your savings for retirement.

For example, you may need the money the day you retire. You may receive a separate pension, or your spouse may continue working after you retire.

“A target-date fund is blind to all that,” Jones said. “What we find is that people, as they age and they accumulate more financial assets, their needs become more complex.”

So as you approach your retirement date, check the stocks portion of your target-date fund and make sure you’re comfortable with how much risk it’s carrying.

“See if it’s in your comfort zone,” said Michael Henkel, managing director of retirement services at Envestnet Asset Management in Chicago. “That date is a date you use in charting the asset allocation over time so you know when it needs to be at its least risky.”

Another factor affecting the performance of target-date funds is that most are overseen by professional money managers whose own performance varies.

“Even among funds that have the same equity-bond mix, you have the variation in performance because some managers were making various types of bets, for instance, investing in deep-value stocks or risky mortgage securities,” Jones said.

Kohl said his Senate committee found that the stock holdings of 2010 target-date funds range from 8 percent to 68 percent.

But according to a target-date index created by Dow Jones, “a firm’s asset class allocation for 2010 target-date funds should be around 27 percent in equities,” he said.

“Despite this, a number of large investment firms have equity holdings well over 50 percent, exposing employees to excessive risk and, ultimately, huge financial losses,” Kohl said.

Investors also should pay close attention to a target-date fund’s fees, which cut into the fund’s return.

A mutual fund’s cost of doing business is reflected in its expense ratio, which is expressed as a percent of its assets.

Expense ratios for target-date funds often have two components: the price tags of the underlying holdings and any fees the fund company charges for overseeing the overall portfolio.

In a target-date fund, “typically, you would be paying no more than 0.75 percent as an expense ratio,” Jones said. “With a larger plan, those fees will typically be lower. You certainly should not be paying 1 percent.”

Target-date funds are still valuable to investors, but their flaws really manifested themselves in the recent stock-market downturn.

“What 2008 brought into clear focus was that in times of economic stress, of market volatility, these differences in risk tolerance among individuals and these differences in investment methods from fund to fund become very, very apparent,” Jones said.

Investors also have some misperceptions about target-date funds. Some think that they will be able to retire on the fund’s target date.

“The misperception is that they have this guarantee,” Henkel said. “It’s not that you can’t retire on the target date. It’s, do you have enough money there to fund your income? It’s a function of the capital markets and did you save enough?”


(c) 2009, The Dallas Morning News. Source: McClatchy-Tribune Information Services.