Last Updated May 11, 2009 8:47 PM EDT
Target date funds are balanced funds that provide a "one stop shopping" experience for investors, offering a broadly diversified mix of stocks, bonds and money markets, automatically rebalancing their asset allocation. The twist is that these funds "age" along with their investors, and their asset mix grows more conservative over time as the fund owners approach retirement. (In industry jargon, that slowly-adjusting asset allocation is known as a fund's "glide path.")
There's no denying the appeal of taking the vital asset allocation decision out of the hands of investors who don't feel comfortable making those decisions on their own. The concept is so appealing, in fact, that the Pension Protection Act of 2006 formally permitted employers to use target date funds as a default investment option for retirement plan participants. Thanks in large part to that endorsement, assets have poured into these funds. Through March, target date funds have seen $1 billion of net cash flow since 2007, while stock funds have seen $150 billion of net cash outflow during the same period.
But all target retirement funds are not created equal, a fact which has caught the attention of the folks in Washington. In a speech this past Monday, SEC Chairman Mary Schapiro said that her agency is "closely reviewing target date funds' disclosure about their glide paths and asset allocations."
Last month, Senator Herb Kohl, D-Wis, announced that he was asking both the SEC and the Department of Labor to determine if target date funds needed additional oversight or restrictions to keep their asset allocations in check.
These examinations have been spurred by the tremendous losses that many target date funds endured last year. The average fund in Morningstar's Target Date 2015-2020 category fell nearly 30 percent last year. Even worse, 2010 target date funds -- designed for investors who plan to retire next year -- lost an average of nearly 23 percent in 2008 -- surely enough to crimp the retirement plans of even the most careful investor.
Even more troubling than the losses, however, is the wide disparity in the asset allocation of funds with similar goals. You might think that one fund designed for an investor retiring in 2010 would, to a large degree, look much like the next. But that's most definitely not the case.
According to Lipper data, AllianceBernstein's 2010 Retirement Strategy Fund holds nearly 62 percent of its assets in stocks. At the other end of the spectrum, the DWS Target 2010 Fund allocates just 13 percent of its portfolio to equities. That stark contrast led to very different results last year: the AllianceBernstein fund fell 32 percent, while the DWS offering lost just 3.6 percent.
Thus it's easy to see why regulators and legislators are considering placing limits on how aggressively these funds can invest. But while they're pondering the issue, use your own common sense. Don't just plow into a fund merely because the date in its name corresponds with your expected retirement date. Make sure that you're comfortable with the amount of equity risk it's assuming.
An additional consideration in choosing a target date fund is just what it owns. These funds are typically funds of funds, which means that they invest in the sponsoring mutual fund firm's other funds. T. Rowe Price's target date funds, for instance, invest in other T. Rowe Price funds.
Unfortunately, only a handful of mutual fund firms have a broad enough -- and good enough -- selection of domestic stock, international stock, bond and money market funds to warrant such concentration. For that reason, many target retirement funds are a mediocre at best collection of mutual funds.
The Oppenheimer Transition 2010 Fund, for instance, owns 13 other Oppenheimer funds. Only two of the underlying funds are above average, as indicated by a Morningstar rating of four or five stars. On the other hand, five of the Oppenheimer funds it owns are below average, rated one or two stars. Included in the latter group is the particularly dreadful Oppenheimer Core Bond Fund, which holds 22 percent of the Transition 2010 Fund's assets. The Core Bond Fund's 35 percent loss last year was a big factor in the Transition 2010 Fund's 41 percent decline in 2008.
The final consideration in choosing a target retirement fund is, of course, expenses -- nothing is a better indicator of future performance. And funds of funds like these provide an opportunity to examine the character of your mutual fund provider. Because these funds, by and large, simply place your assets in a collection of other funds, they don't incur any expenses directly, so there's no reason for them to charge anything beyond the expenses of the funds it invests in.
Yet many target date funds do precisely that. It's hard for mutual fund managers to pass up an opportunity to garner additional fees, and so many of them apply an extra level of fees for the privilege of letting their computer lower your stock allocation every few months.
To determine if a target date fund you're considering is guilty of this double-dipping, take a look at its prospectus. If it tells you that the fund is charging anything other than "acquired fund expenses," keep looking for another alternative.
So, like many of the mutual fund industry's offerings, target retirement funds are a bit of a mixed bag. Done right, they're a fine alternative for the millions of investors who have neither the time nor the inclination to take a hands-on approach to investing, and can provide a simple, low-cost way to build a broadly diversified portfolio. Done wrong, they're just a collection of high-cost, poorly performing mutual funds wrapped up in a new package.
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