How to choose a target date fund that's right for you

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(MoneyWatch) Target date funds, or TDFs, in 401(k) plans frequently miss the money-generating mark for many people despite their popularity as a one-stop retirement investment solution for non-professional investors. "Ready, fire, aim" might most accurately summarize the retirement investment strategy adopted by many people regarding TDFs. Let's see how and why you should change your strategy to "ready, aim, fire."

Growth in TDFs has been explosive. According to a 2012 report by Morningstar, assets in TDFs grew from $71 billion in 2005 to $378 billion by the end of 2011. Vanguard reports that 82 percent of its retirement plans now offer TDFs, and nearly one-fourth of participants invest only in a TDF. Recent federal legislation and regulations that approved TDFs as default investment options helped contribute to this rapid growth.

What exactly are target date funds?

TDFs are mutual funds that invest in a mixture of stocks, bonds, cash and other investments. They are intended to be used as retirement investments throughout your life. When you're in your twenties, thirties and forties, the TDF invests heavily in stocks under the theory that you'll have decades to ride out stock market ups and downs.

As you age and your investing time horizon shrinks, the TDF gradually invests more of your money in conservative bond and cash investments to reduce your exposure to stock market volatility in the years leading up to, and during, retirement. Supposedly, all you need to do is tell the TDF your target year of retirement, and the fund does all the investing and rebalancing for you.

The basic concept behind target date funds is great -- in theory. The devil is in the details in the actual application, particularly when you reach your fifties and beyond. If you don't pay attention to these details, you might find yourself experiencing large losses just before retirement. For example, many TDFs experienced losses of 25 to 30 percent or more during the 2008 financial crisis, slamming investors who were preparing to retire.

Most target date funds devote 80 percent or more of their assets to stocks when retirement is greater than 25 years away. Before reaching your forties and fifties, this allocation should allow you time to ride out stock market declines -- with a very large caveat. With such a high allocation to stocks, you'll experience significant losses during market downturns, which are inevitable during your career. (We've had four in just the past 26 years.) If you can stay the course and remain invested during market downturns, then hopefully the market will come back and you'll recoup your losses -- if history repeats itself. For example, most TDFs have now recouped all their losses and much more since the housing meltdown.

Once you're within 25 years of retirement, most target date funds use a "glide path" that gradually moves your investments from stocks to more conservative investments. In the target date fund industry, however, there's a wide variation in the steepness of the glide path and the eventual allocation to stocks in retirement. That's a critical detail that needs your attention.

When a target date fund may not be right for you

If you'll lose sleep at night and can't stay the course when the stock market heads south, you'll need better aim when selecting your investments. You'll probably want to find a more conservative investment that devotes more assets to bonds and cash investments. In this case, you might pick a TDF with a target year of retirement that's much earlier than your actual retirement and has a lower allocation to stocks. In other words, don't just blindly choose a TDF based on your expected year of retirement. Look at the underlying mix between stocks and bonds, and make sure you're comfortable with the amount of exposure to stock market volatility. It's ok to choose a TDF with a different target date than your actual retirement date.

On the other hand, if you don't want any chance that your investment can decline, then you should have little or no exposure to stocks. In this case, a TDF is just not appropriate for you and you'll want to select more conservative investments, such as stable value funds or short to intermediate bond funds.

Another issue to consider is the fund's philosophy regarding active versus passive management and related fees. Many studies have shown that over the long run, passively managed equity funds with low fees have outperformed actively managed equity funds with higher investment management fees (a topic explored at length by my CBS MoneyWatch colleaguesLarry Swedroe and Allan Roth.) This conclusion applies to any mutual funds with stock investments, including target date funds. Ideally you'll invest in a target date fund with low investment management fees. Recent 401(k) fee disclosure requirements enable you to determine the fees that are charged by the funds in your plans.

If you're not confident that you can choose the best investment for your goals and comfort level, you might want to consider consulting a financial advisor. Just be aware that target date funds, when properly selected for your goals and circumstances, can efficiently deliver investment results similar to a custom-managed portfolio. For that reason, many investment advisors don't like target date funds because they're competition, and they may not want to recommend them.

To get the best advice, be upfront with your advisor about what you're looking for -- a TDF that best fits your goals and circumstances -- and stick to your guns if they try to recommend other investments.

Keep an eye out for my next post, which examines the critical considerations for target date funds when you terminate employment or are within five to ten years of retirement.

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    View all articles by Steve Vernon on CBS MoneyWatch»
    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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