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Are You Choosing the Wrong Target-Date Fund? How To Get It Right

Are you confused about choosing investments in a company 401(k)? More than three-quarters of the plans try to solve the problem for you by offering target-date mutual funds -- one-stop shopping for savers who want to simplify their lives. You can buy them for Individual Retirement Accounts, too.

I like these funds, but picking the right one isn't as obvious as it seems. A lot of new thinking has been going on since the Panic of 2008. You might want to change your target-date strategy, depending on how old you are.

In concept, target-date funds are the ideal investment choice for most retirement savers. They're named by year -- target-date 2015, 2020, 2025, and so forth, up to 2050 so far. You choose a fund dated close to the year you expect to retire. If you're currently 30, you might go for the 2045 fund, which is the year you'll be 65. If you're 50, you'd target 2025.

Each fund holds a mix of assets appropriate to your age. For 30-year-olds, that means stock-owning mutual funds. For 50-year-olds, it's still primarily stocks but with a higher allocation of bonds. As you approach retirement, your fund reduces the percentage of stocks you hold but never switches mainly to bonds. At 65, you'll still be roughly 50 percent or more in stocks.

Many target-date funds lost 25 percent or more in 2008, potentially wrecking retirements for people newly leaving the workforce but having little or no effect on the young. Given these risks, how should you pick a target date?

If you're in your 20s, 30s, and 40s, use the fund that targets your expected retirement date. All of them are primarily in stocks. That's the right allocation for people with a lifetime of working years ahead.

If you're in your 50s, your strategy might change. Look at the percentage of your fund that will be in stocks when you're 65 (it's on the fund's website). For the sake of illustration, say that it's 50 percent.

If you have substantial assets, are in good health, and feel confident about your job, you might want to be more aggressive. Instead of the age-appropriate 2025 fund, you might switch to the 2030 fund. It will own more stock because it's designed for people who are younger than you. It might even be age-appropriate if you're providing for a much younger spouse.

On the other hand, if your assets are modest, your health is poor, or you couldn't stand a big loss in the few years before and after retirement, you should turn conservative -- say, by switching to a 2020 fund, which owns less stock. "If you have just enough money to buy dinner, how much risk should you take to be able to buy dessert?" asks employee benefits attorney Fred Reish, of the law firm, Reish & Reicher. "The truth is, no risk. You can't afford dessert."

If you're in your early 60s, consider your strategy again. Some companies let you stay in the 401(k), which preserves your current investments and holds down your costs. Most employees, however, cash out when they leave the job. If you're happy with your target-date mix of stocks and bonds, roll your money into the same or equivalent funds in an IRA. If stocks are down and you switch to bonds, you'll lose your chance to recover your losses when the market turns up, as it has in the past two years. If you allocate more to bonds, it's a sign that you've been taking more risk than you really wanted.

Target-date funds typically hold more in stock at retirement than investors say they want. In a study of the investors in its target funds, Vanguard reported that 71 percent aim for holding just 10 to 40 percent in stocks when they reach retirement. Yet Vanguard's 2010 Fund, for today's newly retired, is 49 percent in stocks. Fidelity's 2010 stock exposure is 52 percent. T. Rowe Price allocates 56 percent. New retirees who didn't know that were shocked when their funds plunged in value during the financial collapse.

You can hold target-date funds after you retire. But again, they continue to hold a higher percentage in stocks than people say they want. Check it out.

You'll eventually get more disclosure about the target-date funds you buy. Both the Department of Labor and the Securities and Exchange Commission have proposed rules requiring funds to clarify how they work, how much you'll have in stock at your expected retirement date, and when the fund reaches its most conservative allocation. That's all to the good, but investors don't reliably read disclosures, much less understand what they mean. In 401(k) plans, the responsibility falls on your company to choose funds that will meet your goals.

Are employers (the plan sponsors) choosing the right funds for their 401(k)s? Yes, for younger employees, questionable for older ones. On the one hand, new retirees or their spouses might live beyond 90. On paper, you'll need stocks for growth over 30 retirement years. But if stocks turn south just when you retire, you might never recover.

Some employers are becoming aware of this issue, says Edward Lynch of Dietz & Lynch Capital, an advisor to sponsors of 401(k)s. If they want employees to stay in the 401(k) past retirement, the traditional, higher-stock approach might be best, he says. If not, companies are "tending to look toward a higher fixed-income component as people get closer to retirement, because that makes them more comfortable."

That move toward less risk isn't showing up yet, in actual plans. It might never happen unless stocks take another lurch down and new retirees lose money again, says Kerry Pechter, editor of the Retirement Income Journal. If this worries you, control your exposure to stocks yourself. Choose your target date fund, not by your age but by the amount of risk you want to take.

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