3 Cautionary Tales of Target-Date Funds

Why you shouldn't be too quick to judge their performance

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Target-date retirement funds, designed as age-appropriate portfolios to help investors achieve their retirement goals, have been widely slammed for their poor performance during the stock-market meltdown. Funds designed for people who will reach retirement age in 2010--just a year from now--fell by roughly 25 percent in 2008. That may be less than the 38 percent drop for all-stock mutual funds, but the 2010 funds include large percentages of bonds and were viewed as more conservatively managed. On the face of it, a guilty verdict is the right call.

Or is it? Here are three things investors should keep in mind when it comes to target-date funds:

Not all funds are created the same. "The funds did work," says Vanguard economist John Ameriks. "Younger investors were exposed to more risk, while older investors were exposed to less risk." Distant target-year funds contain more equities and are thus more exposed to short-term market risk. "Target-date funds are a very, very reasonable way to achieve your retirement income and funding needs," notes Rod W. Bare, director of asset allocation strategies at Morningstar. "Some people are quick to paint the divergence in 2010 [fund] returns as a case that something is broken, but not all 2010 funds should perform the same." Because people have different needs and income goals, fund companies offer target-date choices that employ different risk profiles. Low-risk doesn't mean risk-free. Target-date funds emerged as an attractive choice for 401(k) plans after retirement-plan rules were changed in 2006's Pension Protection Act. The changes made it easier for employers to enroll people in their plans, and they also encouraged employers to make default investment choices for those who didn't do so for themselves. What easier decision than to take an employee's age, calculate the year they reach 65, and then invest in a target-date fund built for that precise year?

Once an investor signs on to a target-date fund, the fund companies handle most of the details, including setting the initial mix of stocks and bonds held by the fund, rebalancing those percentages regularly, and over time, adjusting the fund's mix to reflect the changing age of the fund's owners. "Many target-date funds are presented as essentially a one-stop shopping solution," says Morningstar analyst Michael Herbst. "That may have created the impression they were low risk, [but] I'm seeing losses over the past year [in funds with 2010-2014 targets] of 28 or 31 percent or, in one case, even 39 percent," he says. "The idea that funds could be sustaining these kinds of losses two or three years from retirement is an ugly shock. There's just no way around that."

The long haul may be longer than you think. It's understandable to think a 2010 target-date fund should reflect near-zero risk. After all, the fund's investors are turning 65 that year and have been told repeatedly that people at or near retirement should not be in risky investments. But as a spokesman at T. Rowe Price emphasized, these funds are designed for the very long haul. The firms says its T. Rowe Price Retirement 2010 fund, for example, is built on the premise that investors may live another 30 years and therefore will need the fund to perform well beyond 2010. A risk-free investment, or one that minimizes stocks in favor of less volatile holdings, just isn't likely to provide the income that investors need in their later years, he said. The T. Rowe target fund's prospectus notes that fund portfolios are not designed to reach their most conservative equity weightings until 30 years after their target date.

T. Rowe's 2010 fund (symbol TRRAX), which is heavier on stocks than many other 2010 funds, was off 25 percent last year (By comparison, Fidelity's 2010 fund, by far the largest of the 2010 funds, was off more than 24 percent.) Over longer periods, T. Rowe maintains, that allocation should help the fund achieve higher returns than its peers. However, the fund hasn't been around that long and remains in negative territory for the past five years. "We are still big believers that the basic philosophy [of target-date funds] is still good," says Ameriks of Vanguard, whose 2010 fund lost 20 percent in 2008. "It's not the design of these funds that was the problem. It was the markets."