Target-Date Funds Proving a 'Set and Forget' Choice

401(k) investors who keep large portions of their portfolios in such funds rarely move out of them.

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Employees with 401(k) holdings in target-date funds seldom move out of them, even during tumultuous market swings, according to a new study from the Employee Benefit Research Institute (EBRI).

"Once [target-date funds] are used, they are very likely to continue to be used for a number of years afterward," EBRI said. "Consequently, the auto-enrollment of participants into [target-date funds] appears likely to stick, which means that the asset allocation within the [funds] is likely to be the asset allocation these participants will have while they remain in their 401(k) plan."

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Target-date funds hold a portfolio of stocks and bonds designed to match the shifting risk tolerances of investors at different ages. A 2050 fund, for example, would tend to have a significant allocation to stocks because it's designed for younger investors who can afford to take on more risk. A 2015 fund, by contrast, would likely have a more conservative portfolio because it's designed for people reaching retirement age in 2015.

Target-date funds automatically adjust their investment risk to more conservative positions, making them "set and forget" choices for many investors. They have become increasingly popular default choices in many 401(k) plans, meaning employees who do not make a specific election decision for their 401(k) funds will have those funds placed in a target-date fund closest to their retirement age.

During the 2007-2008 market decline, many 2010 target-date funds experienced steep losses. Fund managers were criticized for having riskier holdings than many investors expected. Since then, some fund companies have developed more conservative profiles for their target-date funds. Most fund companies, however, have tried to explain to investors that longevity gains and longer retirements argue for maintaining large percentages of target-date funds in stocks even for older investors.

Despite the criticism of many target-date funds, they have continued to be popular core holdings in 401(k) accounts. The popularity of the funds has slowly risen, the EBRI study found. Its conclusions are based on records of more than 20 million 401(k) investors in more than 50,000 different employer plans. In 2007, nearly 39 percent of these investors were using target-date funds, EBRI said, and this percentage grew to 42.6 percent in 2008 and 43.2 percent in 2009.

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As for investors who were automatically enrolled in target-date funds as a default 401(k) choice, nearly all of them stayed in the plans. Among 2007 auto-enrollees, EBRI said, "97.2 percent were still using [target-date funds] in 2008, and 95.7 percent used them in 2008 and 2009." Even among target-date fund investors who were not auto-enrollees, more than 90 percent continued to invest in the funds during the three-year period.

And for those who had all of their 401(k) invested in a target-date fund in 2007, EBRI said, 83 percent were still 100 percent invested in 2009, and another 13 percent had an average of more than 72 percent of their 401(k) in a target-date fund.

Older investors with more experience with 401(k)s and higher account balances were less likely to use target-date funds. "The percentage of participants in 2009 using [target-date funds] ranged from 57.7 percent for those with less than two years of [401(k)] tenure to 24.5 percent of those with 30 or more years of tenure. By account size, 55 percent with an account balance less than $5,000 were in [target-date funds] in 2009, compared with 30.4 percent of those with a balance of $200,000 or more."

While the funds have proven popular, investors should still carefully evaluate returns of the target-date funds offered in their retirement plans. Odds are, they won't have a broad choice of fund companies, but they still can choose from among different target periods offered by one company.

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Despite having identical target dates, there is substantial variation in investment performance among funds. This reflects not only investment choices by fund managers, but also the funds' pre-set decision about the shifting mix of stocks and bonds each holds. This mix is commonly called a fund's "glide path." Even if investors are set to reach retirement age in, say, 2020, they may find the glide path of a fund company's 2015 or 2025 fund more aligned with the level of risk they prefer.

Ibbotson Associates, a unit of Morningstar, tracks the performance of 379 target funds with at least 12 months of performance data. These funds had assets of nearly $385 billion at the end of June. Ibbotson tracks performance across 13 series of target-date funds, from income funds designed for people who have already reached retirement age to funds dated 2055.

During the second quarter, returns within target categories varied by 2 to 3 percent for most categories. The best 2015 fund, for example, gained 1.7 percent during the quarter, while the worst declined by three-tenths of a percent.

The three largest companies providing target-date funds—Fidelity, Vanguard, and T. Rowe Price—continued to see strong growth, Ibbotson said. Among the 22 largest series of target-date funds tracked by the company, its highest ratings went to American Funds, J.P. Morgan, T. Rowe Price, and Vanguard. The two providers with the lowest ratings were AllianceBernstein and Oppenheimer.

Twitter: @PhilMoeller