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How aggressive is your target fund?

Target date funds

Target date funds are supposed to find the best retirement investments for you. If only they could get that allocation right

The success of any investment strategy depends largely on how you allocate your money among the various asset classes. Research has found that the mix of asset types within a portfolio will explain about 90 percent of its return. The actual stocks, bonds, or funds you select are of secondary importance.

Yet many Americans are misguided when it comes to allocation. A worrisome number of retirement accounts are tipped too much in one direction or the other, according to 2007 data from the Employee Benefits Research Institute (EBRI). Of the estimated 50 million Americans who participate in a 401(k) or similar retirement savings plan, 13 percent own absolutely no stocks. At the other end of the continuum, 43 percent have 80 percent or more of their holdings in stocks, which is an allocation that might suit savers just starting out, but not those nearing retirement, or conservative investors of any age.

Investing by autopilot

Enter the target-date fund, which does the allocation for you. Offered by more than 70 mutual fund companies, they are designed to help you match your investment strategy to the year you expect to retire. In theory, you can direct all your contributions into a single target-date fund, and the fund managers will take care of the rest. Over time, the allocations within the fund will be adjusted, shifting you toward more conservative investments as you get closer to retirement. This gradual process is referred to, in industry parlance, as the fund's glide path.

Target-date funds are generally cheaper than stand-alone stock and bond funds. The median expense ratio of target-date funds is 0.68 percent, slightly lower than the median of 0.71 percent for equity funds.

So target-date funds should be the killer app of retirement plans, and they're off to a good start, at least in terms of growth. Since Congress passed the Pension Protection Act of 2006, which encourages employers to automatically enroll new workers in 401(k) plans unless they opt out, companies that offer retirement saving plans almost always provide a target-date fund as the default option. EBRI found that 7 percent of all 401(k) assets in 2007 were held in target-date funds, and that percentage has increased since then.

But different funds with the same target dates employ different asset-allocation strategies, as we detailed in an August 2008 Money Lab analysis. The financial crisis last fall helped to illustrate the potential consequences of those differences. The average fund with a target date of 2010 lost 23 percent in 2008, according to Morningstar. But the 2008 returns of the 2010 funds were all over the map. The best performer lost 3.6 percent and the worst lost 41.8 percent, even worse than the 37 percent loss for the Standard & Poor's 500.

Is more oversight needed?

Those differences also drew the attention of regulators and lawmakers. Earlier this year, the Senate Special Committee on Aging encouraged two federal agencies to investigate target-date funds to see if they might require more regulation.

In June, about 30 fund managers, financial advisers, and consumer advocates presented their views in Washington, D.C. Most cautioned against setting hard guidelines on how target-fund assets should be allocated. Edward Moslander, senior vice president at TIAA-CREF, noted, "There is no right or perfect glide path."

Michael Drew, a finance professor at the Griffith Business School in Queensland, Australia, even said that the typical glide path is actually wrong, and that savers should increase stock holdings as they near retirement. His rationale is that savers are giving up tremendous upside potential and only guarding against the most pessimistic of scenarios.

Same target, different paths

If your retirement investments are held in an IRA, you can decide among the many companies that offer target-date funds. But most 401(k) participants generally have only one fund family to choose from. Some mix-and-match custom menus are starting to appear, where a glide-path manager decides which target-date funds are best for the employees. In a sense, finding the right target-date fund is like shopping for new clothes. You may know you are a size 10, but some brands run larger or smaller, and it could be that for some labels a size 8 is the best fit for you.

There may be no perfect 2015 target-date fund, but you should at least be sure that you're getting somewhere close to the industry average and not an allocation that another fund family would use for its 2025 target-date fund (see "Stock exposure varies"). And if it turns out that your 401(k) plan offers the most aggressive target funds, consider dialing back your target date a notch by choosing the 2015 fund instead of the 2020.

Toward that end, this month the CR Money Lab once again looked at the largest target-date funds to help you determine which might be the best fit for your retirement money (see "How aggressive is your target fund?"). We've listed the fund families from most aggressive to most conservative. So, for instance, Alliance Bernstein was most aggressive and AIM Independence the least in the 2020 funds. We also show the expenses and average returns of the funds over the past 12 months.

Naturally, in this bear market the more aggressive families will have lost more money. But in the end, investors still must know themselves. Find where you fall in the conservative-to-aggressive spectrum, choose the target-date fund that's the best fit, and stick to the plan. That's easier said than done, but as we've seen from the roller-coaster ride of the past year, it's better to resist the temptation to grab the controls and let the target-date fund autopilot take you at least close to your destination.

Target fund tips

Don't buy more than one target-date fund

A recent survey by Janus Investments found that two-thirds of its participants had investments in more than one target-date fund. Similarly, Vanguard notes that less than half of its plan participants who use target-date funds invest all their savings in a single fund. But these funds are designed to be the only investment you need. Combining different years will skew your allocation and the result might not be appropriate for you.

To or through?

Many funds continue to adjust allocations after the target date, but some don't. Find out how your fund allocates assets after the target year.

Check the fund every year.

As we've reported previously, some fund managers tinker with the glide path. For instance, the managers of Charles Schwab target-date funds, among others, significantly shifted stock exposure downward this year, which may or may not be in line with your personal risk tolerance. You can find a fund's allocation in its shareholder reports, which are updated twice a year.

Stock exposure varies

If you like the target-date concept, try to find a fund whose glide path—the gradual shift from stocks to bonds as your retirement year draws near—matches your investing approach. The most aggressive fund group has 65 percent of its 2010 portfolio in stocks, about the same as the most conservative 2040 portfolio.

Stock exposure chart

This article appeared in Consumer Reports Money Adviser.

Posted: August 2009 — Consumer Reports Money Adviser issue: September 2009