What's Under the Hood of Your Target-Date Fund

Investment and expense trends of this increasingly popular 401(k) investment option

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Target-date funds splashed onto the 401(k) scene barely half a dozen years ago and now account for more than half a trillion dollars in retirement plan holdings. They are the fastest-growing segment of employee 401(k) holdings, and their continued growth is widely forecast.

The funds took off after a 2006 federal law encouraged retirement plans to provide participants with investment options in which members would be automatically enrolled. Target-date funds automatically adjust their holdings and change their mix of stocks and bonds to reflect the need for their owners to reduce investment risks as they approach retirement.

[Read: Will Your Target-Date Fund Retire Before You Do?]

The funds are offered in five-year series keyed to when owners turn 65, and fund managers have adopted consistent years: 2015, 2020, 2025, and so on. Vanguard, Fidelity and T. Rowe Price control about 75 percent of all target-date fund assets.

Employees who held target-date funds before the recession often had a sketchy understanding of the funds. Surveys showed widespread perceptions that the funds were somehow shielded from market losses and that they were also free from all management fees and expenses. The 2007-2008 market plunge saw steep losses in many target-date funds, and subsequent studies showed that many funds generated high fees to their plan sponsors and investment managers.

Since markets began recovering in 2009, target-date fund performance and fees have been closely watched. Historically, employees interested in a target fund were limited to a single family of funds offered in their retirement plans. Increasingly, however, employers are providing multiple target-date fund choices to employees.

Choices are still limited, but the prospect of more competition has caused funds to respond to adverse performance reports. Several fund families have gone out of the business altogether, and low-cost funds have enjoyed enough popularity to force competitors to reduce fees and adopt similar investment styles.

Funds are normally compared by their series years, and the key metrics tracked by Morningstar and others include investment returns, fees and what are called glide paths – a measure of a target fund's shifting concentration of stock and bond ownership over time.

[Read: 5 Tips for Savvy Target-Date Fund Investing.]

Historically, ownership of stocks has produced higher returns than ownership of bonds. But movements in stock prices have been more volatile than those for bonds, making stocks a higher-risk holding in the short term. Because older investors are particularly vulnerable to stock declines, target-date funds shift their holdings into bonds over time.

Morningstar recently released its 2012 annual report on target-date funds. Here are its major findings:

1. Rising markets have made most target-date funds look good since the end of 2011. Fund series with heavy equity ownership percentages performed the best but also had more volatile performance swings during periods when markets dipped.

2. Target-date fund fees continue to fall. The average expense ratio, Morningstar said, declined to 0.91 percent of assets in 2012 from 0.99 percent in 2011 and 1.04 percent in 2008.

3. Index funds and other passively managed investments are growing in popularity. They charge much lower fees than actively managed funds. In 2012, Morningstar reported that more new money flowed into passively managed than actively managed target-date funds. Market leader Vanguard has led the way with passively managed target-date fund fees that averaged only 0.18 percent of assets.

[See: Top Rated Target-Date Mutual Funds.]

4. Target-date funds are placing more of their assets in investments outside the United States. Looking at the 2040 series of target-date funds, for example, Morningstar found that international stocks comprised 36 percent of the series' equity holdings last year, compared with 24 percent in 2005.

5. Target-date fund families have substantially different glide-path strategies, Morningstar found. "Target-date funds can be far from interchangeable with one another," the report said. Morningstar conducted extensive performance scenarios using different glide paths and concluded the differences did not greatly affect the likelihood that investors would have sufficient retirement savings though age 85.

This is the typical life expectancy of a 65-year-old woman (it's about 83 years for a 65-year-old man). However, target-date funds with higher equity shares in their glide paths turned out to perform better for people in the 10 years between ages 85 and 95. "The results serve as a reminder that investors or plan sponsors choosing more conservative target-date funds don't just simply lower their market-risk exposure," Morningstar said. "They take on longevity risk – the possibility of outliving savings – in return."

Here is a list of the 10 largest fund families offering target-date funds, and some key performance metrics from Morningstar:

Top 10 Target Date Firms in 2012
Fund Family Net Assets (billions) Average Morningstar Star Ratings* Average Expense Ratios* 2013 Morningstar Rating
Fidelity Investments $157.2 2.75-3.81 .19-.95 Neutral
Vanguard $124.4 3.72 0.15 Gold
T. Rowe Price $80.2 3.51 0.79 Gold
Principal Funds $21.0 3.25 0.87 Neutral
Wells Fargo Advantage $13.8 Not Listed 0.63 Neutral
American Funds $13.3 3.95 0.96 Silver
TIAA-CREF Mutual Funds $12.7 3.53-3.58 .23-.60 Bronze
John Hancock $9.8 3.72 0.92 Neutral
JPMorgan $9.4 3.72 0.87 Silver
American Century Investments $6.6 3.32 0.96 Bronze
         
*Range for families with multiple series of target funds.    
Source: Morningstar        
Some value investors have held their own by updating their strategies in this upbeat market