The Truth About Target-Date Funds

A new report reveals the weaknesses of these much-lauded investment vehicles.

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Target-date funds, which shift into more conservative asset allocations as investors age, have been hailed as the easiest way for people to keep their portfolios balanced over time. They’ve also been criticized for their fees, allocation choices, and losses. The personal finance queen herself, Suze Orman, has warned people against them, calling them oversimplified since they base their allocations on age only.

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Now, the Government Accountability Office has released its own well-researched opinion on these popular investment vehicles. The verdict? Some target-date funds do well, but some do not, which means they aren’t the answer for investors hoping to outsource the hard work of researching investments and balancing portfolios. Investors still need to research their options, check in regularly to make sure their portfolios are diversified and age-appropriate, and learn about fees and returns.

Top findings from the report:

Target-date funds vary almost as much as investors themselves. Some target-date funds get relatively conservative as investors approach retirement, with one-third or less of assets invested in equities, but others keep the allocation to equities closer to 60 percent or higher.

There’s no one-size-fits-all for expected returns, either. The GAO calculated that between 2005 and 2009, returns on target-date funds ranged from a 28 percent gain to a 31 percent loss. In one case, a target-date fund for people retiring last year lost 40 percent of its value just as investors were nearing retirement.

Fund managers themselves don’t even agree on the ideal allocation for investors nearing retirement. One manager told the GAO that keeping 60 percent of one’s portfolio invested in stocks, even in retirement, is best way to stay ahead of inflation and reduce the risk of running out of money. Other fund managers dismissed such strategies as too risky, and argued for avoiding the potential big losses that can occur when such a high percentage of one’s portfolio is in equities.

Perhaps partly because target-date funds are marketed as a relatively hands-off vehicle that participants don’t need to constantly monitor, the GAO found that investors often understand little about how they work and how their money is invested.

Employees who are automatically enrolled in employer-sponsored plans often select target-date funds as the default investment since the funds are thought to automatically shift into appropriate allocations based on age. In fact, GAO reports that at Vanguard, 80 percent of plans selected target-date funds as the default investment in 2009, up from 42 percent in 2005. That makes the findings in this report relevant to a large chunk of employers and employees, who might be invested in target-date funds without even fully realizing it.

Despite their increasing popularity, many target-date funds have scant history; some of the biggest ones have been around for only six years.

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Target-date funds offer clear benefits, which helps explain that popularity: Because they shift assets over time, investors often feel they don’t need to put the effort into deciding how to rebalance on their own. “TDFs thereby can help plan participants and other investors avoid common investment mistakes, such as a lack of diversification and a failure to periodically rebalance their assets,” says GAO.

Target-date funds also vary greatly in the fees that they charge, with expense ratios ranging from 0.19 percent to 1.71 percent.

What this means for investors: Target-date funds can be helpful, but they don’t relieve investors of the burden of doing their own homework to make sure their portfolios make sense for them. Investors who will not remember to check in and rebalance their investments could benefit from some of the automatic shifting into more conservative securities, but the funds can also provide a false sense of security, and lull investors into being more passive than they would be otherwise.

Do you invest in target-date funds? If so, what do you like and not like about them?

Kimberly Palmer is the author of the new book Generation Earn: The Young Professional’s Guide to Spending, Investing, and Giving Back.