Target-Date Funds Finally Showing Solid Gains

First rise in nearly 2 years isn't likely to quell pressure for added oversight and disclosure.

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Target-date mutual funds, which are designed to produce optimal returns based on a planned retirement date, are moving closer to their moment of truth. Will they be scapegoats for nearly universal disgust over last year's Wall Street collapse? Or will they prove to be the right idea for retirement investing?

[See 4 Myths About Target-Date Funds.]

The funds have become increasingly popular since a 2006 law encouraged employers to offer "automatic pilot" default choices in their retirement plans. That's what target-date funds are designed to do: automatically shift investment holdings away from stocks into more conservative investments as their owners age. But critics complain that the funds' heavy losses last year (funds designed for 2010 retirees lost, on average, 25 percent of their value) revealed they were too heavily invested in stocks. Another critique: The funds failed to adequately disclose their underlying risks. However, with few exceptions, fund managers have strongly defended the design and performance of target-date funds.

[ See how target-date funds have recently performed.]

Given the sour public mood over shattered retirement nest eggs, legislators and regulators have understandably provided critics with plenty of airtime in congressional and regulatory oversight hearings. Recently, the Department of Labor and the Securities and Exchange Commission sponsored a hearing to see if oversight rules for the funds are needed. Testimony from Richard Dunne, founder of QDIA.com, which provides services to retirement-plan sponsors, was echoed by other critics:

"A simple analysis of performance data for 62 target date funds with a target date at or before 2010 shows that in the six-month period from June to November of last year, the median fund incurred a cumulative loss of 23 percent and the worst performing fund lost 43 percent of its assets. Even allowing for difficult market conditions, the severity of these losses reflects serious flaws in the construction and management of target-date funds. The fact that U.S. workers were exposed to, or in many cases, automatically defaulted to invest in such flawed products also suggests serious deficiencies in the understanding, selection and monitoring of these funds by plan fiduciaries."

After six consecutive quarterly losses, target-date funds finally posted a solid gain in the second quarter of the year, according to Ibbotson Associates, a unit of Morningstar. Ibbotson, which tracks 312 target-date funds that have been around at least a year, reported that the average fund gained 15.5 percent last quarter, compared with a 15.9 percent gain for the S&P 500 index (the broader Wilshire index of 5,000 stocks rose 16.8 percent). And although funds have been criticized for being too heavily invested in stocks, it was precisely such weightings that produced higher returns. "As we typically observe," the Ibbotson report said, "the aggregate stock-bond split was the primary driver of return differences." Tom Idzorek, Ibbotson's chief investment officer and director of research, notes that the idea of a quarterly review of these funds' performance is "a little silly" given that they are designed as lifetime investment vehicles. And he doubts that a single healthy quarter will lessen scrutiny of the funds. "If we have six consecutive good quarters, maybe all the debate goes away," he said, "but after six consecutive bad quarters, it makes sense for people to question these funds."

Ibbotson's take on the DOL-SEC oversight hearings is that they will eventually lead to higher levels of transparency and disclosure of the funds' equity holdings and the risks associated with investing. Another result, Ibbotson says, is that there will be more clarification about whether the funds' shifting equity mix—known as their "glide path"—is designed to take people to their retirement dates or well beyond. Fund managers have stressed that increases in life expectancy means that target-date funds should be holding a significant weighting of stocks for 20 or even 30 years past their target date. Many critics, however, think the funds have been marketed as less-risky investments, implying that once the target date passes, the fund will shift to much more conservative equity holdings.

Alicia Munnell, head of the Center for Retirement Research at Boston College, thinks the disclosures will help consumers and employers make better decisions when it comes to their retirement funds. But she's clear that last year's losses should not be used to club the funds. "I think financial meltdowns are bad things," she says. "The fact that these funds did poorly in a financial meltdown doesn't mean a thing." Her colleague, research economist Anthony Webb, is concerned that Washington will levy excessive burdens on the funds to mollify critics and investors who lost a lot of money. "The danger is that Congress will decide that households should not be exposed to any investment risks at all," he says. The result would be mandated curbs on equity components of retirement funds. "And this would lead to very, very poor retirement outcomes."