Yes, there are perils in target-date funds
For people who lack the time, expertise or inclination to put together their own retirement portfolios, asset management firms have increasingly marketed “target date” mutual funds as a no-worry, hassle-free solution.
The idea: You put the bulk of your retirement savings into a fund pegged to your target date -- the approximate time you expect to retire. Over the decades, without any action by you, the fund’s holdings gradually become more conservative, leaving you with a comfortable nest egg.
It hasn’t exactly worked out that way, so far at least.
Many target-date funds -- even those for investors in or near retirement -- have suffered stinging losses in the current bear market.
For example, funds designed for people who have already retired or expect to by next year -- portfolios that you would normally want to be relatively low risk -- have lost on average a quarter of their value over the last 12 months, according to fund tracker Morningstar Inc. Two funds lost more than 30% and one skidded more than 40%, even after counting dividends paid.
The wide variation in performance largely reflects the funds’ varying degrees of exposure to stocks -- the higher the stock allocation, the worse the loss in the last year -- and have reignited a debate about how much in stocks is too much for people closing in on retirement.
The target-date struggles show the need to carefully assess a fund’s holdings and investment philosophy to determine how they mesh with your financial circumstances and overall portfolio.
“This bear market has underlined the risks of target-date funds,” said Greg Carlson, a Morningstar analyst. “Target-date funds are a very viable choice, but you really do have to look under the hood.”
Target-date funds, which fund companies began marketing in the late 1990s, have grown quickly in popularity and now hold $140 billion in assets, an impressive amount but only about 1.5% of the $6-trillion total invested in U.S. mutual funds. Boosting that growth, legislation enacted in 2006 allows employers to use target-date funds as a default destination for employees’ 401(k) contributions -- the rationale being that a target-date fund would probably be a suitable retirement investment for practically anyone.
A target-date fund typically invests in other mutual funds managed by the same firm, usually at least a stock fund, a bond fund and a money-market fund.
The longer the time to the target retirement date, the bigger the percentage invested in stocks. As the date approaches, money is shifted into bonds and cash.
But even among funds with the same target date, their allocations can differ significantly.
For so-called 2010 funds that are at least 3 years old, stock allocations range from 14% to 63%, according to Morningstar. For 2020 funds, the band is zero to 88%.
Some fund families -- such as T. Rowe Price and Vanguard -- tend to have higher stock allocations.
T. Rowe’s 2020 fund, for example, has almost 72% of its assets in stocks compared with a 63% average weighted by assets for funds of that vintage.
That more aggressive stance is necessary to keep people from running out of money in the later years of retirement, said Jerome Clark, manager of T. Rowe’s retirement funds.
Despite the market’s recent battering, he said, strong stock performance during bull markets will help compensate for losses in down years.
“In and of itself, 2008 isn’t going to determine whether an individual is successful in their retirement savings,” Clark said. “It’s going to be the accumulation of years of returns.”
In the bull market that ran from 2003 to 2007, some target-date fund managers boosted their stock allocations after they were criticized as too conservative.
Vanguard, for example, boosted its concentration by at least 10 percentage points in all its target-date offerings. The increase neared 20 percentage points in some funds.
Fund groups with lighter stock holdings say those with more in equities underestimated the danger of a prolonged down market after several decades of generally strong returns.
“We can’t imagine someone spending 40 or 50 years of their life saving up and then losing 40% to 50% of their money all in one year,” said Ron Sweet, who manages target-date funds at the USAA mutual fund group. “Sometimes this industry gives this false hope of just sticking more in stocks and that will bail you out.”
Mark Wilson, a financial planner at Tarbox Group in Newport Beach, called target-date funds a smart option, despite their problems, because even knowledgeable investors have trouble putting together well-diversified portfolios and keeping up with routine rebalancing.
Too often, an investor will look at the list of funds in his or her 401(k) and “put 25% there and 25% there and 25% there,” Wilson said. “That’s not how you put together portfolios.”
Financial experts say an investor’s first step should be to compare a target-date fund’s equity exposure with the investor’s financial circumstances and risk tolerance, both current and expected.
Many funds give their target asset allocations online or in prospectuses, typically saying the actual allocations can range up or down 5 percentage points from the target levels. Some funds, however, have wider swings, so it’s worth asking the fund company before investing. You’ll probably also need to call if you want to know allocations for sub-sectors, such as foreign stocks or small-cap stocks.
Don’t feel obligated to match an expected retirement date with a corresponding fund, especially if it’s through a 401(k) retirement account offering only one fund family, some experts say. Someone retiring in 2020, for example, could pick a 2025 fund for extra stock exposure or a 2015 fund for extra safety.
Although it’s reasonable to have a target-date fund constitute the bulk of your portfolio, some advisors say it’s also OK to supplement it by investing in another fund or funds, said John Ameriks, head of Vanguard’s investment counseling and research group.
If you’re “looking to build a portfolio that meets your basic needs,” he said, “then I think you should start with a target-date fund and think about what, if anything, you’d like to add around the edges of that.”
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(BEGIN TEXT OF INFOBOX)Tracking the markets
Real estate
Funds that own real estate investment trusts continued to plummet in the first quarter on fears that the housing market’s crash would spread to commercial real estate, including offices, apartment buildings and warehouses.
Treasuries
Some investors who fled to government debt for safety last fall, at the peak of the financial crisis, pulled away this year as fears subsided somewhat. But inflation-protected bonds shined as worries grew about the long-term inflation outlook.
Foreign stocks
Emerging-market funds showed surprising resilience in the quarter as stocks jumped in Brazil, China, Russia and other markets. But European stocks struggled, and the strong dollar also hurt returns on foreign shares in general.
Municipal bonds
Investors were lured back to muni debt in the first quarter after yields surged on the tax-free bonds in the fourth quarter. Rising tax rates in California and elsewhere also boosted the bonds’ appeal.
Precious metals
Funds that own gold and silver mining stocks jumped as the metals’ prices rallied for much of the quarter. Gold topped $1,000 an ounce in February before pulling back in recent weeks.
Technology stock
Tech stocks held up better than the broad market in January and February, then helped lead the rally in March. The strength of the classic growth sector suggested that investors were betting on an economic rebound.
